Cutting back on Debt.
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 recognise how important financial analysis is to running a successful business.
What is the ideal capital structure a business needs in its industry
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → The smaller the volatility, the more debt you can afford.
Option (1) The smaller the volatility, the more debt you can afford. — Correct. The passage says: “The smaller the volatility, the more debt you can afford.” Volatility means how much sales and earnings go up and down. Interest on debt must be paid every time, so a business with steady earnings can safely carry more debt.
Option (2) The higher the volatility, the more debt you can afford. — Incorrect. The link is reversed for high volatility. The passage says the higher the volatility, the less debt you should have, because earnings may fall just when interest is due.
Option (3) The smaller the volatility, the less debt you should have. — Incorrect. This mixes the two halves of the passage. Small volatility goes with more debt, not less.
Option (4) The higher the debt to equity ratio, the more debt you can afford. — Incorrect. A high debt-equity ratio means the business already has a lot of debt. That leaves less room for more borrowing, not more.
Note: The passage is the NCERT box ‘Cutting Back on Debt’ from the chapter Financial Management, which has been reproduced by NTA in the exam.
NCERT (2026-27 Edition): “Cutting Back on Debt … 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.” |