Question 61 from UPSC CSE 2020 - ECONOMICS

Question

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.

IASCODEX · Accepted Answer

Correct Option: A. 1 and 2 only

Strategy: - Understand the definition and purpose of the Interest Coverage Ratio (ICR).
- Confirm the accuracy of statements 1 and 2 regarding ICR's use by banks for present and future risk assessment.
- Identify statement 3 as incorrect, noting that a higher ICR indicates stronger, not weaker, debt-servicing capability.
- Eliminate options that include statement 3 to determine the correct answer (option A).

Key Info: Interest Coverage Ratio (ICR) is a financial metric used to determine a firm's ability to pay interest on its outstanding debt. It is calculated as: ICR = Earnings Before Interest and Taxes (EBIT) / Interest Expense.

- A higher ratio indicates stronger ability to meet interest obligations, reflecting a lower financial risk for lenders and better debt-servicing capability. It is often used by banks, creditors, and investors to assess the present and emerging risk profile of firms seeking loans or investment.

- An ICR below 1.5 is generally considered risky, while higher values demonstrate better creditworthiness.

- Statement 1 refers to the current (present) risk assessment capability, while Statement 2 refers to anticipating possible future (emerging) risk through trends in the ratio.

- Statement 3 is factually incorrect as a higher ratio is favorable, showing a firm easily meets interest payments; thus it enhances a firm's borrowing credentials.

- In India, the ICR is a key financial health indicator in credit appraisal by banks and is relevant for regulatory compliance in the financial sector.

IASCODEX · Answer

Option B: 2 only

IASCODEX · Answer

Option C: 1 and 3 only

IASCODEX · Answer

Option D: 1, 2, and 3