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62

Question 62

What is the importance of the term "Interest Coverage Ratio" of a firm in India?
1. It helps in understanding the present risk of a firm that a bank is going to give loan to.
2. It helps in evaluating the emerging risk of a firm that a bank is going to give loan to.
3. The higher a borrowing firm's level of Interest Coverage Ratio, the worse is its ability to service its debt.
Select the correct answer using the code given below:

AOptions

A
A) 1 and 2 only
B
B) 2 only
C
C) 1 and 3 only
D
D) 1, 2 and 3

BSolution

The 'Interest Coverage Ratio' (ICR) is a financial metric that assesses a company's ability to meet its interest payment obligations. It is calculated as Earnings Before Interest and Taxes (EBIT) divided by Interest Expense. A higher ratio indicates a better ability to service debt.

  • 1. It helps in understanding the present risk of a firm that a bank is going to give loan to. This statement is correct. A bank uses the ICR to gauge how easily a firm can cover its current interest payments from its operating profits. A low or declining ICR indicates higher present risk of default.

  • 2. It helps in evaluating the emerging risk of a firm that a bank is going to give loan to. This statement is correct. By analyzing the trend of the ICR over time and considering future projections of the firm's earnings and interest obligations, banks can assess how the firm's debt-servicing capacity might evolve, thus indicating emerging risks.

  • 3. The higher a borrowing firm's level of Interest Coverage Ratio, the worse is its ability to service its debt. This statement is incorrect. A *higher* Interest Coverage Ratio means the firm has more earnings (EBIT) available relative to its interest expenses, indicating a *better* ability to service its debt. Conversely, a lower ratio signals higher risk.

Therefore, statements 1 and 2 are correct.

Diagram for Q62

CStrategy

For questions on financial ratios, learn the formula, what the ratio measures, and what a higher or lower value indicates about a company's financial health. Understand their practical application in financial analysis.

DSyllabus Analysis

This question falls under the Indian Economy, specifically related to financial markets, corporate finance, and banking operations.

EQuestion Analysis

Medium. It requires knowledge of basic financial ratios and their interpretation in the context of lending and risk assessment.