T.S. Grewal Class 12 Vol 3 Chapter 4 Q.78 - Accounting Ratios

Question 78

The Debt to Capital Employed Ratio of a company is 0.4:1. State, giving reasons, which of the following will improve, reduce, or not change the ratio:
(i) Sale of Machinery at a loss of ₹50,000.
(ii) Purchase of Stock-in-Trade on two months’ credit for ₹80,000.
(iii) Conversion of Debentures into Equity Shares of ₹5,00,000.
(iv) Purchase of Fixed Assets for ₹4,00,000 on a long-term deferred payment basis.

Solution

(i) Sale of Machinery at a loss of ₹50,000 — Improve
Reason: The loss reduces Equity (and hence Capital Employed) by ₹50,000; Debt is unaffected. A smaller Capital Employed with Debt unchanged increases the ratio.

(ii) Purchase of Stock-in-Trade on credit for ₹80,000 — No Change
Reason: This only affects a Current Asset (Stock) and a Current Liability (Creditors), neither of which is part of Debt or Capital Employed.

(iii) Conversion of Debentures into Equity Shares of ₹5,00,000 — Reduce
Reason: Assume Debt = ₹40,00,000 and Capital Employed = ₹1,00,00,000 (ratio 0.4:1). This transaction decreases Debt by ₹5,00,000 (Debentures cancelled) and increases Equity by the same ₹5,00,000 (new shares issued) — since Capital Employed = Debt + Equity, these two effects exactly offset, leaving Capital Employed UNCHANGED at ₹1,00,00,000, while Debt falls to ₹35,00,000.
New Ratio = 35,00,000 ÷ 1,00,00,000 = 0.35:1 (a reduction from 0.4:1).

(iv) Purchase of Fixed Assets for ₹4,00,000 on a long-term deferred payment basis — Improve
Reason: This creates a long-term liability, increasing Debt by ₹4,00,000; since Debt is part of Capital Employed, Capital Employed also increases by the same ₹4,00,000. Adding the same amount to both a ratio’s numerator and denominator, when the ratio is below 1, moves it closer to 1, i.e. it improves.