Question

Assuming That the Debt to Equity Ratio is 2 : 1, state giving reasons, which of the following transactions would  (i) increase; (ii) Decrease; (iii) Not alter Debt to Equity Ratio:

Answer 1

Let’s take Debt and Equity as Rs 2,00,000 and Rs 1,00,000

`"Debt- Equity Ratio" = "Debt"/"Equity" = 200000/100000 = 2 : 1`

(i) Issue of new shares for cash (say Rs 50,000)

Debt to Equity Ratio =`200000/(100000 + 50000) = 1.33 : 1` (Decrease)

(ii) Conversion of debentures into equity shares (say Rs 50,000)

Debt to Equity Ratio =`200000/(100000 + 50000) = 1.33 : 1` (Decrease)

(iii) Sale of a fixed asset at profit (say Rs 50,000 profit)

Debt to Equity Ratio = `200000/(100000 + 50000) = 1.33 : 1` (Decrease)

(iv) Purchase of fixed asset on long term payment basis (say Rs 50,000)

Debt to Equity Ratio =`(200000 + 50000)/100000 = 2.5 : 1` (Increase)

(v) Payment to creditors (say Rs 50,000)

Debt to Equity Ratio = `200000/100000 = 2 : 1` (No change)