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 a loan to.
2. It helps in evaluating the emerging risk of a firm that a bank is going to give a 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:

1. 1 and 2 only
2. 2 only
3. 1 and 3 only
4. 1, 2 and 3

Explanation

Statement 1 is correct

• The Interest Coverage Ratio (ICR) helps in understanding the present risk of a firm by indicating how easily a company can pay interest on its outstanding debt with its earnings. It shows the firm’s ability to service its debt.

Statement 2 is correct

• The ICR can also provide insight into emerging risks, as a declining ICR could signal future financial trouble and increased risk of default.

Statement 3 is incorrect

• A higher Interest Coverage Ratio indicates a better ability to service debt, as it shows that the firm earns significantly more than its interest obligations.

Answer: (a) 1 and 2 only; Difficulty Level: Easy