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:
Explanation
The Interest Coverage Ratio (ICR) measures how easily a commercial enterprise can pay interest expenses on its outstanding debt with its available operating earnings:
– Formula: Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expenses.
– Statement 1 is correct: Creditors and lending institutions compute the ratio to gauge current solvency and immediate default risk before sanctioning loans.
– Statement 2 is correct: Tracking multi-year ICR trends allows prospective lenders to anticipate emerging financial distress, operational volatility, and credit deterioration.
– Statement 3 is incorrect: A higher ICR denotes that the firm generates operating profits multiple times higher than its interest obligations, indicating stronger financial health and superior ability to service debt (an ICR below 1 indicates an inability to cover interest from earnings).
Therefore, statements 1 and 2 are correct — Option A.