Question

‘Net Asset Turnover’ ratio of a company is 2 times. State with reason whether the following transactions will increase, decrease or not affect the ratio:
Cash sales ₹ 3,00,000
Issue of equity shares ₹ 10,00,000
Issue of 9% debentures ₹ 5,00,000
Credit purchase of goods ₹ 50,000

Hint:

Net Asset Turnover Ratio = Net Sales / Net Assets

• Transactions affecting only Net Sales \(\Rightarrow\) Change ratio
• Transactions affecting only Net Assets \(\Rightarrow\) Change ratio inversely
• Transactions affecting both in same proportion \(\Rightarrow\) May change depending on existing ratio
• Transactions with equal offsetting effects on Assets and Liabilities \(\Rightarrow\) No change in Net Assets, hence no change in ratio

Answer 1

We need to analyze the impact of each transaction on the Net Asset Turnover Ratio.
Step 1: Understand the formula for Net Asset Turnover Ratio. 
\[ \text{Net Asset Turnover Ratio} = \frac{\text{Net Sales}}{\text{Net Assets}} \] Where:

• Net Sales = Gross Sales - Sales Returns
• Net Assets = Total Assets - Current Liabilities (or alternatively, Capital Employed = Shareholders' Funds + Long-term Debts)

Alternatively, Net Assets = Non-Current Assets + Working Capital Step 2: Analyze each transaction. 
(i) Cash sales ₹ 3,00,000

• Cash sales increase Net Sales by ₹ 3,00,000.
• Cash sales also increase Cash (Current Asset) by ₹ 3,00,000, so Net Assets increase by ₹ 3,00,000.
• Effect on Ratio:
  • Numerator (Net Sales) increases
  • Denominator (Net Assets) also increases
  • Percentage increase in numerator vs denominator? If initial Net Sales and Net Assets are in proportion (ratio 2:1), then:
  • Suppose initial Net Sales = 2x, Net Assets = x
  • New Net Sales = 2x + 3,00,000
  • New Net Assets = x + 3,00,000
  • New Ratio = (2x + 3,00,000)/(x + 3,00,000)
  • Compare with 2 = 2x/x
  • If x>3,00,000, the new ratio& Lt;2; if x& Lt;3,00,000, new ratio>2
  • Since we don't know x, but generally sales are revenue items and assets increase by same amount, the ratio may decrease slightly because the incremental ratio (1) is less than the existing ratio (2)
• Reason: Both numerator and denominator increase by the same amount, but since the existing ratio is >1, the addition of equal amounts will decrease the ratio.
• Effect: Decrease

(ii) Issue of equity shares ₹ 10,00,000

• Issue of shares increases Shareholders' Funds, hence Net Assets increase by ₹ 10,00,000.
• Net Sales are not affected by this transaction.
• Numerator (Net Sales) remains unchanged.
• Denominator (Net Assets) increases.
• Therefore, the ratio decreases.
• Effect: Decrease

(iii) Issue of 9% debentures ₹ 5,00,000

• Issue of debentures increases Long-term Debts, hence Net Assets increase by ₹ 5,00,000 (since Net Assets = Shareholders' Funds + Long-term Debts).
• Net Sales are not affected.
• Numerator unchanged, Denominator increases.
• Therefore, the ratio decreases.
• Effect: Decrease

(iv) Credit purchase of goods ₹ 50,000

• Credit purchase of goods increases Inventory (Current Asset) by ₹ 50,000 and also increases Trade Payables (Current Liability) by ₹ 50,000.
• Net Assets = Total Assets - Current Liabilities
  • Total Assets increase by ₹ 50,000 (Inventory)
  • Current Liabilities increase by ₹ 50,000 (Trade Payables)
  • Net Assets = (Assets↑ by 50,000) - (Liabilities↑ by 50,000) = No change
• Net Sales are not affected (purchase is not sales).
• Numerator unchanged, Denominator unchanged.
• Therefore, the ratio remains unaffected.
• Effect: No change