Previous Year Question
What is the importance of the term ‘Interest Coverage Ratio’ of a firm in India?
It helps in understanding the present risk of a firm that a bank is going to give a loan to.
It helps in evaluating the emerging risk of a firm that a bank is going to give a loan to.
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
1 and 3
1, 2 and 3
Correct Answer: A
Detailed Solution
The Interest Coverage Ratio or ICR is a financial ratio that measures how many times a firm can meet its interest expense from its operating earnings.
Its commonly used formula is:
EBIT means Earnings Before Interest and Taxes.
For example, if a company has:
EBIT of ₹12 crore; and
annual interest expense of ₹4 crore;
then:
It means that the company’s operating earnings are three times its annual interest obligation.
General interpretation of ICR
ICR | General indication |
Below 1 | Operating earnings are insufficient even to meet interest payments. |
Around 1 | Interest-payment capacity is weak and highly vulnerable. |
2 | EBIT is approximately twice the interest expense, providing a limited cushion. |
3 or above | A relatively better cushion is available for interest payments. |
Very high | It may indicate a low debt burden or strong earnings. |
An acceptable ICR is not identical for every industry. A stable utility company and a cyclical construction company may require different levels of safety.
Statement 1 is correct
Before granting a loan, a bank examines the company’s existing financial statements, EBIT, interest expense and outstanding debt.
The current ICR indicates:
whether the firm can presently meet its interest payment;
the cushion available to withstand a decline in earnings;
the risk associated with its existing debt burden; and
its immediate probability of default.
ICR therefore helps a bank understand the firm’s present credit risk.
Statement 2 is correct
A bank does not examine ICR for only one year. It evaluates its multi-year trend and the firm’s projected future cash flows.
For example:
Year | EBIT | Interest expense | ICR |
Year 1 | ₹15 crore | ₹5 crore | 3.0 |
Year 2 | ₹12 crore | ₹5 crore | 2.4 |
Year 3 | ₹8 crore | ₹5 crore | 1.6 |
The declining trend indicates that the firm’s debt-servicing capacity is weakening. A future decline in revenue, an increase in interest rates or additional borrowing may further increase its default risk.
ICR is therefore also useful in evaluating a firm’s emerging credit risk.
Statement 3 is incorrect
The statement associates a higher ICR with poorer debt-servicing ability, whereas the actual relationship is the opposite:
Higher ICR ⇒ larger earnings cushion ⇒ better interest servicing capacity
Lower ICR ⇒ smaller earnings cushion ⇒ higher credit/default risk
If Firm-A has an ICR of 5 and Firm-B has an ICR of 0.8, Firm-A will generally possess a stronger interest-payment capacity. Firm-B’s operating earnings are insufficient even to cover its interest expense.
Limitation of ICR
Although important, ICR is not the only ratio used by a bank in a lending decision. It does not directly measure repayment of loan principal, and EBIT is an accounting measure rather than actual cash flow.
A bank may additionally examine:
Debt Service Coverage Ratio;
operating cash flow;
debt-equity ratio;
collateral;
business-cycle and industry risk;
loan-repayment history; and
projected earnings.