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 given 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.
Contents9
- A1 and 2 only
- B2 only
- C1 and 3 only
- D1, 2 and 3
Show answer
Answer: (A) 1 and 2 only
Interest Coverage Ratio (ICR) measures how easily a company can pay the interest on its outstanding debt.
Formula:
ICR = Earnings Before Interest and Tax (EBIT) / Interest Expense
A higher ICR means the company earns much more than its interest payments — it's in good financial health.
A low ICR means the company might struggle to pay its interest obligations.
Statement 1 (Helps understand risk before giving a loan) — CORRECT:
Banks and lenders look at ICR to assess whether a company can handle its debt.
A low ICR means high risk — the company might not be able to pay interest on the new loan.
Statement 2 (Helps evaluate whether company can increase profit) — CORRECT:
ICR shows how much of a company's earnings go toward interest payments.
If ICR is improving, the company is becoming more profitable relative to its debt, suggesting room for growth.
Statement 3 (Helps in evaluating credit rating of a company) — NOT CORRECT:
While ICR is one factor that credit rating agencies consider, it's not the direct purpose of the ratio.
The primary purpose is assessing debt-paying ability, not credit rating.
Answer: A (1 and 2 only).
Key Takeaway:
Interest Coverage Ratio = Earnings / Interest expense.
Used by lenders to assess risk.
Higher = safer.
It does NOT directly determine credit ratings.
Interest Coverage Ratio measures how easily a company can pay interest on its debt by dividing earnings before interest and tax by interest expense.
Banking sector stress and NPAs became a major policy focus around 2018-2020, making financial ratios like ICR critical for loan assessment.
Statement 3 is the trap - ICR helps assess debt-paying ability, not credit ratings directly, though rating agencies may consider it among many factors.
Interest Coverage Ratio (ICR)
Indian Economy Interest Coverage Ratio ICR EBIT Interest Expense
Interest Coverage Ratio: Formula, Interpretation & Banking Applications
ICR = EBIT ÷ Interest Expense — measures debt servicing ability
Higher ICR = Lower Risk — company earns much more than interest payments
Banks use ICR to assess present and emerging loan risk before lending
ICR below 2.5 is generally considered risky by lenders
What ICR Measures
Interest Coverage Ratio shows how easily a company can pay interest on its outstanding debt. It's a key indicator of financial health that banks use before approving loans.
• EBIT = Earnings Before Interest and Tax (operating profit)
• Interest Expense = total interest payments on existing debt
• Result shows how many times the company can pay its interest obligations
ICR Interpretation Guide
ICR Range | Risk Level | Meaning | Bank Decision |
|---|---|---|---|
Above 4.0 | Low Risk | Very safe, earns 4x its interest cost | Loan approved easily |
2.5 - 4.0 | Moderate Risk | Adequate coverage | Loan likely approved |
1.5 - 2.5 | High Risk | Tight coverage, vulnerable | Careful evaluation needed |
Below 1.5 | Very High Risk | Barely covering interest | Loan likely rejected |
Why Banks Use ICR
Present Risk Assessment: Low ICR means company already struggles with current debt — adding more debt increases default risk
Emerging Risk Evaluation: Improving ICR trends show company is growing profits faster than debt — suggests capacity for additional borrowing
Loan Pricing: Banks charge higher interest rates to companies with lower ICR to compensate for higher risk
Monitoring Tool: Banks track ICR quarterly to spot early warning signs of financial distress in existing borrowers
Connection to This Question
Statement 3 was the trap — it claimed higher ICR means worse debt ability. This is completely backwards. Higher ICR means the company earns much more than its interest payments, making it safer, not riskier.
Trap: Higher ICR = worse ability to service debt. Reality: Higher ICR = better ability (more earnings relative to interest)
Confusion: ICR directly determines credit rating. Reality: ICR is one input among many for credit ratings
Mix-up: ICR uses net profit in numerator. Reality: ICR uses EBIT (before interest and tax)
Reversal: Lower ICR = safer company. Reality: Lower ICR = higher risk of default
Banking Risk Assessment Methods
Indian Economy loan risk firm bank
How Banks Assess Lending Risk: Key Financial Ratios & Methods
Banks use multiple financial ratios to assess loan default risk
5 Cs of Credit: Character, Capacity, Capital, Collateral, Conditions
ICR, DSCR, Debt-to-Equity are core ratios for risk assessment
Key Financial Ratios Used by Banks
Ratio | Formula | What It Measures | Safe Level |
|---|---|---|---|
Interest Coverage Ratio | EBIT ÷ Interest Expense | Ability to pay interest | Above 2.5 |
Debt Service Coverage Ratio | Net Income ÷ Total Debt Service | Ability to repay principal + interest | Above 1.2 |
Debt-to-Equity Ratio | Total Debt ÷ Total Equity | Financial leverage | Below 2.0 |
Current Ratio | Current Assets ÷ Current Liabilities | Short-term liquidity | Above 1.5 |
Return on Assets | Net Income ÷ Total Assets | Asset utilization efficiency | Above 5% |
Bank Loan Approval Process
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flowchart TD
s1["`**Application Review**
Basic eligibility, KYC, business profile check`"]
s2["`**Financial Analysis**
Calculate ICR, DSCR, profitability ratios from 3 years statements`"]
s3["`**Credit Score Check**
CIBIL score, existing loan performance, default history`"]
s4["`**Collateral Assessment**
Value and marketability of security offered`"]
s5["`**Risk Rating**
Assign internal risk grade based on all factors`"]
s6["`**Approval/Rejection**
Final decision with interest rate and terms`"]
s1 --> s2
s2 --> s3
s3 --> s4
s4 --> s5
s5 --> s6RBI Guidelines on Credit Risk
Basel III Norms: Banks must maintain minimum capital adequacy ratio of 11.5% (9% + 2.5% buffer)
Asset Classification: Loans overdue for 90+ days must be classified as Non-Performing Assets (NPAs)
Provisioning Requirements: Banks must set aside 15-100% of loan amount as provision based on risk category
Large Exposure Limits: Single borrower exposure cannot exceed 25% of bank's capital
Trap: Banks only look at current financial position. Reality: They assess both present and emerging risk trends
Confusion: Higher ratios always mean better creditworthiness. Reality: Context matters — very high ratios may indicate overly conservative management
Mix-up: Credit rating = loan approval. Reality: Banks do internal risk assessment beyond external credit ratings