Question

Aradya Ltd. had debt equity ratio of 2.5 : 1. State which of the following transaction will not affect the Debt Equity Ratio :

• A. Purchase of Rs 12,00,000 machinery by taking bank loan of Rs 12,00,000
• B. Rs 2,00,000 paid to creditors
• C. Conversion of Rs 1,00,000 debentures into Equity shares of Rs 100 each
• D. Sale of furniture (book value of Rs 5,00,000) for Rs 5,50,000

Hint:

Only consider the impact on long-term debt and equity. Ignore transactions that affect only current liabilities or only the asset side.

Answer 1

The Correct Option is B

Understanding Debt-Equity Ratio:
Debt-Equity Ratio is calculated as: \[ \text{Debt-Equity Ratio} = \frac{\text{Total Debt}}{\text{Shareholders' Equity}} \] This ratio measures the proportion of financing from debt compared to equity. A transaction will affect this ratio only if it changes the numerator (debt) or the denominator (equity).
Option-wise Analysis: \begin{itemize} \item
(1) Purchase of Machinery via Bank Loan:
This increases both assets (machinery) and liabilities (bank loan). Since debt increases and equity remains the same, the debt-equity ratio will increase.
\textit{Impact: Affects the ratio (Increases Debt).} \item
(2) Rs 2,00,000 paid to Creditors:
This reduces current liabilities (creditors) and assets (cash) by the same amount. Since neither long-term debt nor equity is affected, the debt-equity ratio remains unchanged.
\textit{Impact:
Does not affect the ratio.} \item
(3) Conversion of Debentures into Equity Shares:
This reduces debt (debentures) and increases equity (share capital). As both components of the ratio are affected inversely, the debt-equity ratio will decrease.
\textit{Impact: Affects the ratio (Debt ↓, Equity ↑).} \item
(4) Sale of Furniture at Profit:
The sale increases cash (asset) and reduces furniture (asset) by Rs 5,00,000, while the Rs 50,000 profit increases retained earnings, hence increasing equity. So even though liabilities remain constant, equity increases slightly.
\textit{Impact: Affects the ratio (Equity ↑).} \end{itemize}
Conclusion:
Only
Option (2) involves a change in current liabilities and assets that does not impact the capital structure (debt or equity). Hence, it has
no effect on the Debt-Equity Ratio.