Question

The Debt Equity Ratio of Manak Enterprises is 2.5 : 1. Which of the following transaction will result in increase in this ratio?
(A) Purchase of goods on credit ₹ 2,00,000.
(B) Payment to creditors ₹ 3,00,000.
(C) Issue of debentures ₹ 6,00,000.
(D) Sale of furniture of the book value of ₹ 4,00,000 at a profit of 10%.

Hint:

Remember: Debt-Equity Ratio increases when debt increases or equity decreases. New debentures issued raise long-term debt, thus increasing the ratio.

Answer 1

The correct answer is (C) Issue of debentures ₹ 6,00,000.
Explanation: Debt-Equity Ratio = \(\frac{\text{Total Debt}}{\text{Total Equity}}\). It measures the proportion of debt used to finance assets relative to equity. An increase in debt while equity remains unchanged will increase this ratio.
Option A (Purchase on credit) – increases current liabilities (trade payables), but generally not counted under long-term debt for the ratio unless specified. Hence negligible impact on debt-equity ratio.
Option B (Payment to creditors) – reduces current liabilities, lowering total debt, thus decreasing the ratio.
Option C (Issue of debentures) – increases long-term debt, raising total debt, so ratio increases.
Option D (Sale of asset at profit) – increases cash and profits, thus potentially increasing equity, but does not raise debt. Hence the ratio may decrease slightly. Thus, issuing debentures raises the debt side directly and increases the debt-equity ratio.