Question

Debt to Equity Ratio of a company is 0.5:1. Which of the following suggestions would increase, decrease or not change it:

(i) Issue of Equity Shares:

(ii) Cash received from debtors:

(iii) Redemption of debentures;

(iv) Purchased goods on Credit?

Answer 1

Debt Equity Ratio = 0.5:1

Let Long- term Loan be = Rs 5,00,000

Shareholders’ Funds = Rs 10,00,000

Debt-Equity Ratio = `500000/1000000 = 0.5/1`

(i) Issue of Equity shares- Decrease

Reason: Issue of equity shares results in increase in Shareholders’ Funds in the form of equity shares but there will be no change in Long-term Loan.

Example: Issue of equity share Rs 5,00,000

Shareholders’ Funds after issue of equity shares = 10,00,000 + 15,00,000

= Rs 15,00,000

Debt-Equity Ratio = `500000/1500000 = 0.33 : 1`

(ii) Cash received from Debtors- No Change

Reason: Cash received from debtors will increase one current asset in the form of cash and decrease other asset in the form of debtors. This transaction will have no effect on Long-term Loan and Shareholders’ Funds.

(iii) Redemption of Debentures- Decrease

Reason: This transaction will result decrease in Long-term Loans in the form of reduction in debtors and no change in Shareholders’ Funds.

Example: Redemption of Debentures Rs 2,00,000

Long-term Loan = 5,00,000 − 2,00,000 = 3,00,000

Debt Equity Ratio after redemption of debentures = `300000/1000000 = 0.3: 1`

(iv) Purchased of goods on Credit- No Change

Reason: Neither Long-term loan nor share holders’ funds will be affected by this transaction because purchase of goods results no change in Long-term Loan and Shareholders’ Funds.