Question

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?

1. Sale of Machinery at a loss of ₹ 50,000.
2. Purchase of Stock-in-Trade on credit of two months for ₹ 80,000.
3. Conversion of Debentures into Equity Shares of ₹ 5,00,000.
4. Purchase of Fixed Assets for ₹ 4,00,000 on a long-term deferred payment basis.

Answer 1

\[\text{Debt to Capital Employed Ratio} = \frac{\text{Debt}}{\text{Capital Employed}}\]

(Capital Employed = Shareholders’ Funds + Debt)

(i) Sale of Machinery at a loss of ₹ 50,000

Effect: Improves

Reason: The loss on the sale of machinery reduces the Reserves and Surplus (Shareholders' Funds). Since Shareholders' Funds decrease, the total Capital Employed (denominator) decreases while the Debt (numerator) remains unchanged. A decrease in the denominator increases the overall ratio

Example: Let $\text{Debt} = 4,00,000$ and $\text{Capital Employed} = 10,00,000 - 50,000 = 9,50,000$.

$$\text{New Ratio} = \frac{4,00,000}{9,50,000} \approx 0.42 : 1 \ \text{(Improved)}$$

(ii) Purchase of Stock-in-Trade on credit of two months for ₹ 80,000

Effect: No change

Reason: This transaction increases Inventory (Current Assets) and Creditors (Current Liabilities). It does not involve any item of Debt (long-term liabilities) or Shareholders’ Funds. Since neither the numerator nor the denominator changes, the ratio remains unaffected.

(iii) Conversion of Debentures into Equity Shares of ₹ 5,00,000

Effect: Reduce

Reason: Conversion reduces Debentures (Debt) and increases Equity Share Capital (Shareholders’ Funds) by the exact same amount. While the total Capital Employed remains the same (as one component moves to another), the Debt (numerator) decreases, which reduces the overall ratio.

Example: Let initial $\text{Debt} = 6,00,000$ and $\text{Capital Employed} = 15,00,000$ (Ratio = 0.4 : 1). Subtract ₹5,00,000 from Debt:

$$\text{New Ratio} = \frac{6,00,000 - 5,00,000}{15,00,000} = \frac{1,00,000}{15,00,000} \approx 0.07 : 1 \ \text{(Reduced)}$$

(iv) Purchase of Fixed Assets for ₹ 4,00,000 on a long-term deferred payment basis

Effect: Improve

Reason: Buying an asset on a long-term deferred basis creates a Non-Current Liability (Long-term Debt). This increases both Debt (numerator) and Capital Employed (denominator) by ₹4,00,000. Since the initial ratio is less than 1 (0.4 : 1), adding an equal amount to both the top and bottom increases the value of the ratio.

Example: Let $\text{Debt} = 4,00,000$ and $\text{Capital Employed} = 10,00,000$. Add ₹4,00,000 to both:

$$\text{New Ratio} = \frac{4,00,000 + 4,00,000}{10,00,000 + 4,00,000} = \frac{8,00,000}{14,00,000} \approx 0.57 : 1 \ \text{(Improved)}$$