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:

Statement 1 is correct.

• RBI states: "The interest coverage ratio gives an indication regarding the debt servicing capacity of the borrower with respect to payment of interest."
• The interest coverage ratio looks at current year earnings (EBIT) vs current year interest payments. This examines the present earnings cushion to service debt in the same period. A lower ratio indicates higher default risk in near term as earnings may be inadequate to cover interest dues.

Statement 2 is correct.

• RBI states: "A trend analysis of interest coverage ratio would also throw light on the stability or improvement/deterioration in debt servicing capacity over the years."
• Analyzing interest coverage ratio trend gives insight into debt repayment capacity strengthening or worsening over time. For instance, a declining ratio means business growth has not kept pace with rising interest obligations. This highlights intensifying risks going forward.

Statement 3 is incorrect.

• RBI states: "The higher the ratio, the better is the company’s ability to service its debt."
• A higher ratio signifies company's earnings are adequately covering or exceeding interest payments. This allows comfortable servicing of debt.

Source: https://rbi.org.in/Scripts/BS_ViewMasCirculardetails.aspx?id=9908#8