A transaction involving a decrease in debt-equity ratio and increase in current ratio is:

Question

Accepted Answer

The correct option is 2:
The transaction 'Issue of equity shares for cash' simultaneously improves both the solvency and liquidity positions of the company, which is what the question requires. When equity shares are issued for cash, the company's Cash balance (a Current Asset) increases, which raises the Current Ratio (Current Assets / Current Liabilities). More importantly, the company's Shareholders' Funds (Equity) increase, while Debt remains unchanged. Since Equity is the denominator in the Debt-Equity Ratio (Debt / Equity), an increase in Equity will cause the overall ratio to decrease, signifying lower financial risk for the business. This singular transaction is the only option that satisfies both criteria of a decreasing Debt-Equity Ratio and an increasing Current Ratio.

The incorrect option is 1:
Issue of debentures against the purchases of fixed assets involves an increase in Fixed Assets (Non-current Asset) and an increase in Debentures (Long-Term Debt). This transaction increases the numerator (Debt) of the Debt-Equity Ratio, causing the ratio to increase, not decrease. Furthermore, neither Current Assets nor Current Liabilities are affected, so the Current Ratio remains unchanged. Therefore, this option fails both conditions specified in the question.

The incorrect option is 3:
Issue of debentures for cash leads to an increase in Cash (Current Asset) and an increase in Debentures (Long-Term Debt). While the increase in Cash does increase the Current Ratio (satisfying the second condition), the increase in Debt (the numerator) causes the Debt-Equity Ratio to increase, not decrease. For the Debt-Equity Ratio to decrease, the equity base must be strengthened relative to the debt.

The incorrect option is 4:
Redemption of preference shares for cash involves a decrease in Cash (Current Asset) and a decrease in Preference Share Capital (part of Shareholders' Equity). The decrease in Current Assets causes the Current Ratio to fall, which contradicts the requirement for the ratio to increase. Additionally, the decrease in Equity (the denominator) causes the Debt-Equity Ratio to increase (assuming debt is constant), which also contradicts the first condition.