The owner of a small business says, “The bank has agreed to lend us more money, so our debt position must be strong.”
Why is a creditor’s willingness to extend funds not evidence of a strong debt position?
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → The bank may be looking more at collateral than at whether the earnings will justify the debt service.
Option (1) The bank may be looking more at collateral than at whether the earnings will justify the debt service. — Correct. A bank may lend because the loan is backed by collateral. It may not check whether the business’s earnings will cover the interest and repayment. Some lenders are also overzealous to win customers. So a loan offer does not prove the debt is safe.
Option (2) The bank may be looking more at the debt-equity ratio than at the collateral offered by the business. — Incorrect. This reverses the point. Banks do look for a satisfactory debt-equity ratio before lending, but the worry is a bank leaning on collateral.
Option (3) The bank may be looking more at the growth of the business than at its cash flow. — Incorrect. Cash flow is what the owner must study to judge how much debt is safe. The worry is not a bank chasing growth.
Option (4) The bank may be looking more at the industry norms than at the business’s own risk. — Incorrect. Industry volatility helps the owner decide how much debt to take: the more volatile, the less debt. It is not why a bank’s offer misleads.
NCERT (2026-27 Edition):
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