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 = \(\frac{\text{Total Debt}}{\text{Total Equity}}\). This ratio indicates the extent to which debt finances assets compared to equity. An increase in debt with constant equity will elevate this ratio.

Option A (Purchase on credit) – This action increases current liabilities (trade payables). It is typically not classified as long-term debt for ratio calculation unless specifically stated, resulting in a minimal impact on the debt-equity ratio.
Option B (Payment to creditors) – This reduces current liabilities, thereby decreasing total debt and consequently lowering the ratio.
Option C (Issue of debentures) – This action increases long-term debt, leading to a higher total debt and thus an increased ratio.
Option D (Sale of asset at profit) – This transaction boosts cash and profits, which may increase equity. However, it does not add to debt. Consequently, the ratio might experience a slight reduction.
Therefore, issuing debentures directly increases the debt component, resulting in an elevated debt-equity ratio.