UPSC Prelims 2020 Q62: Indian Economy – Banking & Financial Sector

UPSC Prelims 2020, General Studies Paper I · Indian Economy

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:

(a) 1 and 2 only
(b) 2 only
(c) 1 and 3 only
(d) 1, 2 and 3

Answer: (a) 1 and 2 only

Explanation

Interest Coverage Ratio (ICR): Bank Lending Assessment

Statement	Claim	Verdict	Detail
1	Helps understand present risk of firm	TRUE	ICR = EBIT / Interest Expense. High ICR = low immediate default risk. Shows current ability to service debt.
2	Helps evaluate emerging risk (future)	TRUE	Declining ICR trend signals deteriorating ability to service future debt. Forward-looking risk indicator.
3	Higher ICR = worse debt-servicing ability	FALSE	OPPOSITE: Higher ICR = better ability to service debt (more earnings per unit of interest). Lower ICR = worse.

Statements 1 and 2 are correct (statement 3 is inverted). Answer: (a) 1 and 2 only.

Answer: (a) 1 and 2 only.

Why each option is right or wrong

(a) CORRECT. ICR measures both current risk (1) and emerging trends (2). Higher ICR = better debt service, so statement 3 is false.
(b) Incorrect. Statement 1 is also correct.
(c) Incorrect. Statement 3 is false (inverted logic).
(d) Incorrect. Statement 3 is false.

Key point

Interest Coverage Ratio: ICR = EBIT / Interest Expense. >2.5 = healthy, <1.5 = at risk. Declining trend = deteriorating. Helps banks assess default probability.

Remember

Interest Coverage Ratio helps banks understand: (1) Present risk - current ability to service debt through earnings (correct), (2) Emerging risk - future ability based on trends (correct). However, a HIGHER ICR indicates BETTER debt-servicing ability, not worse (statement 3 is false/inverted).

Common mistakes

Assuming higher ratio = worse. Inverse relationship - higher ICR = BETTER debt servicing.
Confusing ICR with debt-to-equity (which higher = worse).
Missing that ICR is backward + forward indicator (past earnings + future stress tests).

Exam tip

Lending ratios: ICR (earnings-based), Debt/Equity (leverage), Current Ratio (liquidity), ROE (profitability). Banks use all together for risk assessment.

Sources

Basel III - Bank Lending Standards
RBI - Credit Risk Management Guidelines

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