Question

Assertion (A): Debt to Equity Ratio expresses the relationship between Long term Debts and Shareholder’s Funds and indicates the long-term financial soundness of the firm.

Reason (R): Debt to Equity Ratio is calculated to assess the ability of the firm to meet its long-term liabilities. A higher Debt-Equity Ratio indicates that large amount of funds invested in business are provided by long-term lenders which is an indication of risky financial position.

In the context of the above statements, which one of the following is correct?

Options

• Both (A) and (R) are true, but (R) is not the correct explanation of (A).

• Both (A) and (R) are true and (R) is the correct explanation of (A).

• Both (A) and (R) are false.

• (A) is true, but (R) is false.

Answer 1

Both (A) and (R) are true and (R) is the correct explanation of (A).

Explanation:

The Debt-Equity Ratio shows the relationship between long-term debt and shareholder funds and helps in determining a company’s financial future. It is calculated to measure the firm’s ability to meet long-term obligations; a higher ratio indicates greater reliance on borrowed funds, which raises financial risk. As a result, both the assertion and the reasoning are correct, and the reasoning accurately explains the assertion.