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: (UPSC Prelims 2020)
Answer: 1 and 2 only
Notes: The correct answer is [A] 1 and 2 only. The Interest Coverage Ratio (ICR) is a critical financial metric used to determine how easily a company can pay interest on its outstanding debt.

• Statement 1 (Correct): The ICR helps lenders understand the present risk. It is calculated by dividing a firm's Earnings Before Interest and Taxes (EBIT) by its interest expenses (ICR = EBIT/ Interest Expense}). A low ratio indicates that the firm is currently struggling to generate enough profit to cover its interest obligations.
• Statement 2 (Correct): By analyzing the trend of the ICR over several quarters or years, banks can evaluate emerging risks. A declining ICR trend suggests that a firm's financial health is deteriorating, signaling potential future default even if they are currently making payments.
• Statement 3 (Incorrect): This is logically reversed. The higher the Interest Coverage Ratio, the better the firm’s ability to service its debt. A high ratio indicates a comfortable margin of safety, meaning the company earns significantly more than it owes in interest. Conversely, a ratio below 1 indicates the firm is not generating enough profit to pay its interest expenses.

In the Indian context, the ICR is a key tool for banks to monitor "stressed assets." A higher ICR implies lower credit risk, making the firm more attractive for lending.