6.Chapter 4 :Ratio Analysis : Solvency Ratios : Debt EQuity Ratios, Assignment # 5

Dear Analysts,
Welcome. As we continue with our Solvency Ratio : Debt Equity Ratio.

Learning Objectives:
To be able to :
* Express the formula of the Debt Equity Ratio.
* Apply the formula of the Debt Equity Ratio

Recapitulation of the Previous Class:

1. Debt Equity ratio:  Measures the relationship between long term debt and shareholders funds. 

It is computed as long term debts divided by shareholders funds.

 where :

Long term debts (also termed as Debt) = non current liabilities
= long term borrowings + other long term liabilities + long term provision

               Shareholders funds (also termed as Equity) = Share capital + Reserves and                     surplus + money received against share warrants

              Normally,  it is considered to be safe if Debt Equity ratio is 2:1.                                  However, it may vary from industry to industry.

              Answer To The Task  ( Given in the Previous Class)

Ques. Calculate debt equity ratio from the following information:
total assets                        1500000
current liabilities                600000
total debts                         1200000

Ans. 

Debt equity ratio = long term debt /shareholders funds
total debts = non current liabilities ( long term debts) + current liabilities
therefore, long term debts = total debts - current liabilities = 1200000 - 600000 = 600000
Now, Total Assets =( Equity and Liabilities) = Shareholders funds + non current liabilities plus current liabilities
therefore, Shareholders funds = total assets - (non current liabilities - current liabilities )
= Total assets - Total Debts
= 1500000 - 1200000 = 300000
Thus, Debt Equity ratio = 600000/ 300000 = 2 :1

Task. 

Assignment # 5

Guidelines:

Debt Equity Ratio of X limited is 0.5 :1.

Which of the following would increase or decrease or not change the debt equity ratio.

Examples.

Debt equity ratio = long term debt/ shareholders funds = 0.5:1 
Assume that long term debts are rupees 500000 and shareholders funds are rupees 1000000.
Now we will analyse the effect of given transactions on debt equity ratio.

1.Further issue of equity shares for cash.

1.Further issue of equity shares for cash . Effect- decrease in the ratio.

 Reason:shareholders funds increase with long term debts remaining unchanged. Assume that one lakh worth of equity shares are issued. This will increase the shareholders funds to 1100000. The new ratio will be 0.45 :1.(5 lakh divided by 11 lakh) Thus, it is clear that further issue of equity shares decreases the debt equity ratio.

2. Cash  received from debtors.

 Cash received from debtors: Effect: not change the ratio .

 Reason: no effect on long term debts and shareholders funds. (This transaction will only affect the composition of current asset. Hence the debt equity ratio will remain unchanged.)

With the guidelines of the above examples, Solve the Transactions given below:

1. Sale of goods on cash basis. 

2. Redemption of debentures.
3. Purchase of goods on credit.
4. Issue of bonus shares. 

Answer to Assignment # 5

1. Sale of goods on cash basis: Effect : not change the ratio. 

Reason: no effect on long-term that's and shareholders funds.

2. Redemption of debentures: Effect: decrease the ratio. 

Reason: long term debts will decrease while shareholders funds remain unchanged. Assume that 100000 debentures are redeemed.

 This will decrease the long-term debt to rupees 400000. The new ratio will be 0.4:1. (4 lakh divided by 10 lakh, i.e. decrease the debt equity ratio)

3. Purchase of goods on credit: Effect: not change the ratio. 

Reason: no effect on long term debts and shareholders funds.

4. Issue of bonus shares: Effect: Not change the ratio. 

Reason: As neither long term debts nor shareholders funds are changing. Shareholders funds will increase and decrease the same amount as bonus shares are issued from the balance of securities premium reserve, where as long term debts remain unchanged.