Question

The debt-equity ratio of a company is 1 : 2. Which of the following suggestions would increase, decrease or not change it?

1. Issue of Equity Shares.
2. Cash Received from Trade Receivables.
3. Sale of Goods on Cash Basis.
4. Repayment of Long term Borrowing.
5. Purchased Goods on Credit.

Answer 1

Debt Equity Ratio = `"Debt"/"Equity" or "Long-term Debts"/"Shareholder’s Funds"`

Since the Debt Equity Ratio in the above issue is 1 : 2, it is fair to conclude that long-term loans total ₹ 1,00,000 and shareholder’s fund shares total ₹ 2,00,000.

(i) Issue of Equity Shares - Decrease

Reason: If ₹ 1,00,000 worth of equity shares are released, the shareholder’s funds will increase to ₹ 2,00,000 + ₹ 1,00,000 = ₹ 3,00,000.
As a result, the updated ratio would be as follows:

= `(1,00,000)/(3,00,000)` = 0.33 : 1

The ratio was 1 : 2 or (5 : 1) before the issue of equity shares, but it has now been reduced to 0.33 : 1, suggesting that the ratio has decreased.
As a result, it can be concluded that an increase in shareholder assets lowered the ratio.

(ii) Cash Received from Trade Receivables - No Change

Reason: Obtaining cash from trade receivables will only affect the cash and trade receivables balances. As a result, the debt-equity ratio will remain unchanged because neither long-term debt nor shareholder funds is affected.

(iii) Sale of Goods on Cash Basis - No Change

Reason: Product exchanges for cash would have an impact only on inventory and cash. As a result, the debt-to-equity ratio will remain unchanged because neither long-term liabilities nor Shareholder’s Funds are affected.

(iv) Repayment of Long term Borrowings - Decrease

Reason: If a long-term loan of ₹ 50,000 is repaid, the Long-Term Debts will be reduced by ₹ 50,000, leaving the overall debt at ₹ 1,00,000 − 50,000 = ₹ 50,000.
As a result, the new ratio would be:

`(50,000 )/(2,00,000 )` = 0.25 : 1

Prior to the repayment of long-term debt, the ratio was 1 : 2 (0.5 : 1), but it is now 0.25 : 1. It signifies a decline in the ratio.

(v) Purchased Goods on Credit - No Change

Reason: Product purchases on credit would have an impact only on inventory and trade payables. As a result, the debt-to-equity ratio will remain unchanged because neither long-term obligations nor shareholder funds are impacted.