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 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 and 2 only
  • 2 only
  • 1 and 3 only
  • 1, 2 and 3

Answer: (a) 1 and 2 only

Interest Coverage Ratio
  • The Interest Coverage Ratio (ICR) is a financial ratio that is used to determine how well a company can pay the interest on its outstanding debts.
  • The ICR is commonly used by lenders, creditors, and investors to determine the riskiness of lending capital to a company. The interest coverage ratio is also called the “times interest earned” ratio.
  • The Interest Coverage Ratio (ICR) of a firm is a measure of its ability to pay its interest expenses on outstanding debt.
  • It is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expenses.
  • A higher ICR indicates that a company is generating sufficient earnings to meet its interest obligations, while a lower ICR suggests that the company may have difficulty servicing its debt.
    • The lower the interest coverage ratio, the greater the company’s debt and the possibility of bankruptcy. Intuitively, a lower ratio indicates that less operating profits are available to meet interest payments and that the company is more vulnerable to volatile interest rates.
    • Therefore, a higher interest coverage ratio indicates stronger financial health – the company is more capable of meeting interest obligations.
Interest Coverage Ratio Formula
  • Primary Uses of Interest Coverage Ratio:
    • ICR is used to determine the ability of a company to pay its interest expense on outstanding debt.
    • ICR is used by lenders, creditors, and investors to determine the riskiness of lending money to the company.
    • ICR is used to determine company stability – a declining ICR is an indication that a company may be unable to meet its debt obligations in the future.
    • ICR is used to determine the short-term financial health of a company.
    • Trend analysis of ICR gives a clear picture of the stability of a company in regard to interest payments.
Debt-Service Coverage Ratio (DSCR)
  • The Debt Service Coverage Ratio (sometimes called DSC or DSCR) is a credit metric used to understand how easily a company’s operating cash flow can cover its annual interest and principal obligations.
  • Because the Debt Service Coverage Ratio also includes principal obligations in the denominator, it’s considered a very useful metric when a corporate borrower has reducing term debt in its capital structure (meaning monthly or annual principal repayments).
  • A higher DSC ratio is better than a lower one, with a typical minimum requirement of 1.25x.
Debt Service Coverage Ratio