[CBSE] Q 79 Solution Accounting Ratios of TS Grewal (2023-24)

Solution of Question number 79 of the Accounting Ratios of TS Grewal Book 2023-24 CBSE Board?

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?

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

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

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

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

[Ans.: (i) Improve, (ii) Not Change, (iii) Reduce, (iv) Improve.]

Solution:-

Solution:-

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

Let’s analyze the impact of selling machinery at a loss of ₹ 50,000 on the debt-to-capital employed ratio

Debt-to-Capital Employed Ratio Formula

Debt-to-Capital Employed Ratio

= Long-Term Debt\Capital Employed

Long-Term Debt = ₹ 80,000

Capital Employed:- ₹ 2,00,000 Includes shareholders’ funds and long-term liabilities (total equity + total debt).

= 80,000/2,00,000 = 0.4 : 1

Impact of Selling Machinery

1. Loss of ₹ 50,000:-

• A loss of ₹ 50,000 reduces shareholders’ funds (reserves or retained earnings), which are part of capital employed.
• The long-term debt remains unchanged.

1. Revised Values

• Initial Capital Employed: ₹ 2,00,000
• Reduction in Shareholders’ Funds: ₹ 50,000
• Revised Capital Employed: 2,00,000 – 50,000 = ₹ 1,50,000

1. Recalculate Debt-to-Capital Employed Ratio:

Debt-to-Capital Employed Ratio

= Long-Term Debt\Capital Employed

= 80,000/1,50,000 = 0.533 : 1 (approx.)

Impact

The debt-to-capital employed ratio Improves from 0.4 : 1 (before the sale) to approximately 0.533 : 1, reflecting higher reliance on debt compared to capital employed.

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

If we consider debt only as long-term liabilities, the purchase of stock-in-trade on credit for two months typically does not directly impact the debt-to-capital employed ratio. Here’s the reasoning:

Debt-to-Capital Employed Ratio Formula:

= Long-Term Debt\Capital Employed

• Long-Term Debt: ₹ 1,20,000
• Capital Employed: ₹ 3,00,000 (includes shareholders’ equity and long-term debt)

= 1,20,000/3,00,000 = 0.4 : 1

Impact of the Transaction:

1. Credit Purchase:

The purchase of stock-in-trade on credit creates current liabilities (accounts payable), which are not part of long-term debt.

Therefore, long-term debt remains unchanged.

2. Capital Employed Unaffected:

• Since the transaction does not impact long-term liabilities or shareholders’ funds, Capital employed remains unchanged.

Final Impact:

• With long-term debt and capital employed staying constant, the debt-to-capital employed ratio remains unchanged at:

Debt-to-Capital Employed Ratio

= 1,20,000/3,00,000} = 0.4 : 1

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

The conversion of ₹ 5,00,000 worth of debentures into equity shares will reduce the debt-to-capital employed ratio, and here’s why:

Debt-to-Capital Employed Ratio Formula:

Debt-to-Capital Employed Ratio

= Long-Term Debt\Capital Employed

1. Initial Values:

• Long-Term Debt (before conversion): ₹ 6,00,000
• Capital Employed (before conversion): ₹ 15,00,000
• Debt-to-Capital Employed Ratio: = 6,00,000/15,00,000} = 0.4 : 1

1. Impact of Conversion:

• Converting debentures (a long-term liability) into equity reduces long-term debt by ₹ 5,00,000, leaving: 6,00,000 – 5,00,000 = ₹ 1,00,000
• The same amount is added to shareholders’ equity, but capital employed (the sum of long-term debt and shareholders’ funds) remains unchanged at ₹ 15,00,000.

2. Revised Values:

• Long-Term Debt (after conversion): ₹ 1,00,000
• Capital Employed (unchanged): ₹ 15,00,000

New Debt-to-Capital Employed Ratio:

Debt-to-Capital Employed Ratio

= 1,00,000/15,00,000 = 0.067 : 1 (approx)

Impact:

• The ratio decreases from 0.4 : 1 to approximately 0.067 : 1, indicating a significantly lower reliance on debt compared to total capital employed.

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

The purchase of fixed assets for ₹ 4,00,000 on a long-term deferred payment basis will impact the debt-to-capital employed ratio as follows:

Debt-to-Capital Employed Ratio Formula:

Debt-to-Capital Employed Ratio = Long-Term Debt\Capital Employed

1. Initial Values:

• Long-Term Debt (before transaction): ₹ 6,00,000
• Capital Employed (before transaction): ₹ 15,00,000
• Debt-to-Capital Employed Ratio:

= 6,00,000/15,00,000} = 0.4 : 1

2. Impact of the Transaction:

• Since the fixed assets are purchased on a long-term deferred payment basis, the long-term debt increases by ₹ 4,00,000.
• The new long-term debt becomes: = 6,00,000 + 4,00,000 = ₹ 10,00,000

• Capital Employed also increases because long-term debt is included in capital employed. The new capital employed becomes: = 15,00,000 + 4,00,000 = ₹ 19,00,000

3. Revised Debt-to-Capital Employed Ratio:

Debt-to-Capital Employed Ratio

= Long-Term Debt\Capital Employed

= 10,00,000/19,00,000 = 0.526 : 1 (approx.)

Impact:

• The debt-to-capital employed ratio improves from 0.4 : 1 to approximately 0.526 : 1, reflecting higher reliance on debt compared to capital employed.

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