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Q32 (IAS/2020) Economy › Basic Concepts & National Income › Risk and return metrics Official Key

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 :

Result
Your answer: —  ·  Correct: A
Explanation

The Interest Coverage Ratio (ICR) is a critical financial metric used to determine how easily a company can pay interest on its outstanding debt. It is calculated by dividing a firm's Earnings Before Interest and Taxes (EBIT) by its interest expenses.

  • Statement 1 is correct: ICR helps lenders assess the present risk by indicating whether the firm’s current profits are sufficient to cover immediate interest obligations.
  • Statement 2 is correct: By analyzing trends in the ICR over time, banks can evaluate emerging risks. A declining ratio suggests potential future insolvency, even if the firm is currently meeting its obligations.
  • Statement 3 is incorrect: A higher ICR indicates a stronger financial position and a better ability to service debt. Conversely, a lower ratio signifies a higher risk of default.

Therefore, Option 1 (1 and 2 only) is the correct choice as it accurately identifies the utility of the ratio for risk assessment while excluding the logically flawed third statement.

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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…
At a glance
Origin: Books + Current Affairs Fairness: Moderate fairness Books / CA: 6.7/10 · 3.3/10
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This question was a direct fallout of the 'Zombie Firms' discussion in the Economic Survey 2018-19/19-20. When the Survey highlights a technical metric (ICR < 1), UPSC asks for its definition and interpretation. It is a conceptual sitter if you understand the basic math: Earnings divided by Interest.

How this question is built

This question can be broken into the following sub-statements. Tap a statement sentence to jump into its detailed analysis.

Statement 1
Does the Interest Coverage Ratio of a firm in India help banks assess the firm's present/default credit risk when considering a loan?
Origin: Direct from books Fairness: Straightforward Book-answerable
From standard books
Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 16: Terminology > 16 Terminology > p. 463
Presence: 5/5
“For the different income sources, payer of the income deducts TDS at the time of making the payment but the WHT is deducted beforehand i.e., even before the payment is made to the payee in order to clear off the liability towards the government.• Zombie (firms): Zombies are typically identified using the interest coverage ratio which is the ratio of a firm's profit after tax to its total interest expense. Firms with interest coverage ratio lower than one are unable to meet their interest obligations from their income and are categorized as zombies.”
Why this source?
  • Defines Interest Coverage Ratio (ICR) as profit after tax divided by total interest expense, linking the metric directly to interest-payment capacity.
  • Identifies firms with ICR < 1 as unable to meet interest obligations and classifies them as 'zombie' firms, which signals high default/present credit risk.
  • Directly connects ICR to a firm's ability to service debt, which is central to bank assessment of credit/default risk.
Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > MCLR > p. 92
Presence: 3/5
“Adopting of multiple benchmarks by the same bank is not allowed within a loan category. Banks are free to decide the components of spread and the amount of spread. But in general, the spread consists of credit risk premium, business strategy, operational costs of banks etc. While the banks will be free to decide on the spread over the external benchmark, credit risk premium can change only when borrower's credit assessment undergoes a substantial change. The other components of the spread like operating cost can be altered once in three years. The interest rate under the external benchmark shall be reset at least once in three months.”
Why this source?
  • Explains that banks set loan spreads including a credit risk premium that changes when a borrower's credit assessment changes.
  • Implies banks perform borrower credit assessments to price loans, supporting the view that financial ratios (like ICR) are used in such assessments.
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