Given below are two statements:
Assertion (A): If a firm’s business risk is lower, its capacity to use debt is higher.
Reason (R): Financial risk refers to a position when a company is unable to meet its fixed financial charges, namely interest payment, preference dividend and repayment obligations.
In the light of the above statements, choose the correct answer from the options given below:
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → Both (A) and (R) are true but (R) is not the correct explanation of (A).
Assertion (A): If a firm’s business risk is lower, its capacity to use debt is higher. — True. Business risk, also called operating risk, depends on fixed operating costs such as rent and salaries. A firm with low business risk can safely take on more debt.
Reason (R): Financial risk refers to a position when a company is unable to meet its fixed financial charges, namely interest payment, preference dividend and repayment obligations. — True. Debt brings fixed charges: interest, preference dividend and repayment. Financial risk is the position where a firm cannot meet these fixed charges.
Why R does not explain A?
A is about business risk and how much debt a firm can carry. R only defines financial risk and says nothing about business risk. A definition of financial risk cannot bring about a link between business risk and debt.
The correct reason for A is that the total risk of a firm depends on both business risk and financial risk. When business risk is low, the firm has room to bear more financial risk, so it can use more debt.
NCERT (2026-27 Edition): “9. Risk Consideration: As discussed earlier, use of debt increases the financial risk of a business. Financial risk refers to a position when a company is unable to meet its fixed financial charges namely interest payment, preference dividend and repayment obligations. Apart from the financial risk, every business has some operating risk (also called business risk). Business risk depends upon fixed operating costs. Higher fixed operating costs result in higher business risk and vice-versa. The total risk depends upon both the business risk and the financial risk. If a firm’s business risk is lower, its capacity to use debt is higher and vice-versa.” |