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:

[UPSC Civil Services Exam – 2020 Prelims]

(a) 1 and 2 only

(b) 2 only

(c) 1 and 3 only

(d) 1, 2 and 3

Answer: (a)        

Explanation:

• Interest Coverage Ratio indicates the ability of a firm to take the loan or debt and repay it within the tenure of the loan. It helps in understanding and evaluating the present risk of a firm that a bank is going to give a loan to. Hence statement 1 is correct.
• It is calculated by dividing a company’s earnings before interest and taxes by the company’s interest expenses for a given period. Hence statement 2 is correct.
• The lower the ratio, the more the company is burdened by debt expense. When a company’s interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable. Hence statement 3 is incorrect.