Q. 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 :
a) 1 and 2 only
b) 2 only
c) 1 and 3 only
d) 1, 2 and 3
Correct Answer : a) 1 and 2 only
Question from UPSC Prelims 2020 GS Paper
Explanation:
Interest Coverage Ratio (ICR)
The Interest Coverage Ratio (ICR) is a financial metric used to determine a company’s ability to pay the interest on its outstanding debt. It is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expenses for the same period. The formula is:
Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expenses
Given the options and the explanation of what the Interest Coverage Ratio signifies, let’s evaluate each statement:
1. It helps in understanding the present risk of a firm that a bank is going to give loan to.
This statement is correct. The Interest Coverage Ratio is indeed used by lenders, including banks, to assess the risk level of lending to a firm. A higher ratio indicates that the firm is more capable of meeting its interest obligations from its operating income, which implies lower risk for the lender.
2. It helps in evaluating the emerging risk of a firm that a bank is going to give loan to.
This statement is also correct. The Interest Coverage Ratio can be used to evaluate not just the current, but also the potential future risk associated with lending to a firm. If a firm’s ICR is declining, it may indicate emerging risks that could affect the firm’s ability to service its debt in the future.
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. The opposite is true; a higher Interest Coverage Ratio indicates a better ability of the firm to service its debt. It means the firm generates significantly more earnings relative to its interest obligations, which is a positive indicator of financial health.
Given the analysis, the correct answer is:
a) 1 and 2 only
