Even successful businesses have debt, but how much is too much? Learning how to manage debt is what can put you ahead. Taking on the right amount of debt can mean the difference between a business struggling to survive and one that can respond nimbly to changing economic or market conditions. A number of circumstances may justify acquiring debt. As a general rule, borrowing makes the most sense when you need to bolster cash flow or finance growth or expansion. But while debt can provide the leverage you need to grow, too much debt can strangle your business. So the question is: How much debt is too much? The answer, experts say, lies in a careful analysis of your cash flow as well as your industry. A business that doesn’t grow dies. You’ve got to grow, but you’ve got to grow within the financial constraints of your business. What is the ideal capital structure a business needs in its industry to remain viable? The higher the volatility (in your industry), the less debt you should have. The smaller the volatility, the more debt you can afford. Although banks and other financial institutions look for a satisfactory debt-to-equity ratio before agreeing to make a loan, don’t assume a creditor’s willingness to extend funds is evidence that your business is in a strong debt position. Some financial institutions are overzealous lenders, particularly when trying to lure or hold on to promising business customers. “The bank may be looking more at collateral than whether the (business’s) earnings are going to come in to justify the debt service. To avoid these and other credit pitfalls, it’s up to you to get the financial facts on your business and make sound borrowing decisions. Unfortunately, many entrepreneurs fail to recognize how important financial analysis is to running a successful business. Even business owners who receive detailed financial statements from their accountants often do not take advantage of the valuable information contained in the documents.
Banks and other financial institutions look for a satisfactory ________ before agreeing to make a loan.
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → Debt-to-Equity Ratio
Option (1) Return on Investment — Incorrect. Return on investment shows how profitably a firm uses its funds. It matters in deciding whether debt will pay, but it is not the ratio the passage names.
Option (2) Debt-to-Equity Ratio — Correct. The passage says banks look for a satisfactory debt-to-equity ratio before lending. This ratio compares the borrowed funds of a firm with the owners’ funds. A firm that already owes a great deal compared with what its owners have put in is a greater risk to a lender.
Option (3) Floatation Costs — Incorrect. Floatation costs are the costs of raising funds, such as brokerage on an issue of shares. They are a factor in the financing decision, not something a bank checks before a loan.
Option (4) Ratio of Non Cash Expenditure over Preference Dividend — Incorrect. No such ratio exists in the chapter.
Note: The passage is the NCERT box ‘Cutting Back on Debt’, which has been reproduced by NTA in the exam. One box in the Financial Management chapter became five questions here. Do not skip the boxes when you read NCERT.
NCERT (2026-27 Edition): “Cutting Back on Debt … Although banks and other financial institutions look for a satisfactory debt-to-equity ratio before agreeing to make a loan, don’t assume a creditor’s willingness to extend funds is evidence that your business is in a strong debt position. Some financial institutions are overzealous lenders, particularly when trying to lure or hold on to promising business customers. …” |