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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

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.
Statement 2
Does the Interest Coverage Ratio of a firm in India help banks evaluate the firm's emerging or future 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.
  • Explicitly links low ICR (below 1) to firms being unable to meet interest obligations and classifies them as 'zombie' firms — a clear signal of future/default risk.
Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > MCLR > p. 92
Presence: 4/5
“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?
  • States that the bank's spread includes a credit risk premium that can change only when the borrower’s credit assessment undergoes a substantial change.
  • Shows banks actively assess borrower credit risk and adjust loan pricing based on assessment — implying metrics like ICR inform lending decisions.
Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 16: Terminology > 16 Terminology > p. 457
Presence: 3/5
“You can draw from the line of credit when you need it, up to the maximum amount. You'll pay interest only on the amount you borrow.• Leverage Ratio: It is the proportion of debt that a company has as compared to its equity/shareholders capital.• Liquidity Coverage Ratio (LCR): The LCR is calculated by dividing institution (Banks/NBFCs) high-quality liquid assets (for example cash, govt. securities, securities issued or guaranteed by foreign governments etc.) by its total net cash flows, over a 30-day period. In background of IL&FS and HDFL crisis, RBI on 24th May 2019 proposed introducing LCR for large NBFCs to help tackle liquidity issues in the sector.”
Why this source?
  • Defines leverage ratio (debt relative to equity), illustrating that financial ratios are standard tools to summarise a firm’s risk profile.
  • Supports the general principle that ratios are used by lenders and regulators to evaluate solvency and creditworthiness alongside measures like ICR.
Statement 3
Does a higher Interest Coverage Ratio for a borrowing firm in India indicate a worse ability to service its debt?
Origin: Web / Current Affairs Fairness: CA heavy Web-answerable

Web source
Presence: 5/5
"Thus, companies with a higher interest coverage ratio can absorb more adversity, are more likely to pay interest on time, and are hence less likely to default."
Why this source?
  • Explicitly states that companies with a higher interest coverage ratio can absorb more adversity.
  • Directly links a higher ratio to being more likely to pay interest on time and less likely to default, contradicting the claim that higher is worse.
Web source
Presence: 5/5
"A poor interest coverage ratio, such as below one, means the company’s current earnings are insufficient to service its outstanding debt."
Why this source?
  • Explains that a poor (low) interest coverage ratio — e.g., below one — means earnings are insufficient to service debt.
  • Implying that higher ratios indicate sufficient earnings to service interest, so higher is not worse.
Web source
Presence: 4/5
"This low ratio suggests a limited buffer to absorb unexpected financial shocks. In case of financial difficulties, the company may struggle to meet its interest payment obligations."
Why this source?
  • Describes a low coverage ratio (1.5) as providing only a limited buffer and causing the company to struggle to meet interest payments under stress.
  • By highlighting risks of a low ratio, it implies that higher ratios give a better ability to service debt, contrary to the statement.

Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 16: Terminology > 16 Terminology > p. 463
Strength: 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 relevant

Defines Interest Coverage Ratio and gives an example rule: firms with ICR < 1 cannot meet interest and are labeled 'zombies', linking low ICR to poor debt-servicing.

How to extend

A student can infer the inverse: if low ICR implies inability to service interest, then higher ICR would generally imply better ability to service interest (contradicting the statement), and verify using firm income/interest data.

Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 8: Financial Market > 2020 > p. 246
Strength: 4/5
“2. One of the most important functions of DCCBs is to provide funds to the Primary Agricultural Credit Societies. Which of the statements given above is/are correct? • (a) 1 only • (b) 2 only • (c) Both 1 and 2 • (d) Neither 1 nor 2 5. 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.”
Why relevant

Contains a direct exam-style item listing 'The higher a borrowing firm's level of Interest Coverage Ratio, the worse is its ability to service its debt' as a proposition to be judged, signaling this is a common tested assertion.

How to extend

A student could treat this as a proposed rule to test against definitions/examples (e.g., compare firms with varying ICRs) to check whether the assertion is a misconception.

Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 16: Terminology > 16 Terminology > p. 457
Strength: 3/5
“You can draw from the line of credit when you need it, up to the maximum amount. You'll pay interest only on the amount you borrow.• Leverage Ratio: It is the proportion of debt that a company has as compared to its equity/shareholders capital.• Liquidity Coverage Ratio (LCR): The LCR is calculated by dividing institution (Banks/NBFCs) high-quality liquid assets (for example cash, govt. securities, securities issued or guaranteed by foreign governments etc.) by its total net cash flows, over a 30-day period. In background of IL&FS and HDFL crisis, RBI on 24th May 2019 proposed introducing LCR for large NBFCs to help tackle liquidity issues in the sector.”
Why relevant

Shows that different financial ratios (Leverage Ratio, Liquidity Coverage Ratio) are used to assess debt and liquidity, implying ICR is one of several metrics for debt-servicing capacity.

How to extend

A student can compare ICR with leverage and liquidity ratios for firms to judge which direction of ICR correlates with better/worse debt-servicing ability.

Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 16: Balance of Payments > 3. Trade Credit > p. 480
Strength: 3/5
“• Trade credit is provided to an importer by overseas suppliers, banks, financial institutions and other permitted recognized lenders. • It allows the importer to pay at a later date for imports of capital/non-capital goods permissible under the Foreign Trade Policy of GOI. • Only a resident of India can take trade credit. Ø. • Under automatic route an amount up to USD 150 million per import transaction for overseas suppliers. Debt Service Ratio: Ratio of debt service payments (Principal + Interest) of a country to that of the country's current receipts is termed as debt service ratio. The debt service ratio of India in 2019-20 remained lower than 7 per cent.”
Why relevant

Gives definition of Debt Service Ratio (country-level) — a related concept measuring principal+interest payments relative to receipts, illustrating the idea of ratios that evaluate debt-servicing capacity.

How to extend

Using the same logic, a student can map how higher or lower coverage/service ratios (country or firm) correspond to relative ease of meeting debt obligations.

Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 9: Agriculture > Debentures > p. 263
Strength: 3/5
“These are the debt instruments with a fixed rate of interest issued by a company and are generally unsecured. It can be for medium or long term and is fully repayable on the maturity date. Many investors prefer debentures because it offers higher rate of interest than fixed deposits (FDs). Interest rates also depend upon the credit rating given by the Credit Rating Agencies (CRAs) such as CARE, ICRA, etc. A lower rated debenture will carry a higher rate of interest because the risk involved is considered high.”
Why relevant

Explains interest rates on debt instruments depend on credit risk/ratings; higher perceived risk (weaker servicing ability) leads to higher interest costs.

How to extend

A student could link ICR to credit rating: firms with low ICR may get lower ratings and face higher interest, so contrasting ICR levels with interest costs helps assess servicing ability.

Pattern takeaway: UPSC picks financial terms from the Economic Survey/News and tests them on three levels: 1. Definition, 2. Utility (Risk assessment), 3. Directionality (Higher is good/bad). Always check the logical consistency of the ratio's name.
How you should have studied
  1. [THE VERDICT]: Sitter. Solvable by pure logic or basic reading of the Economic Survey (Zombie Firms chapter). Source: Vivek Singh/Nitin Singhania or Investopedia.
  2. [THE CONCEPTUAL TRIGGER]: Banking Health & NPA Crisis. Specifically, the identification of 'Zombie Firms' (firms that cannot cover interest payments from profits) and the Twin Balance Sheet problem.
  3. [THE HORIZONTAL EXPANSION]: Master these sibling ratios: Debt-to-Equity Ratio (Leverage), Liquidity Coverage Ratio (LCR), Net Stable Funding Ratio (NSFR), Capital Adequacy Ratio (CAR), Provisioning Coverage Ratio (PCR), and Debt Service Coverage Ratio (DSCR).
  4. [THE STRATEGIC METACOGNITION]: Don't just memorize definitions. Apply the 'Directionality Test': If this ratio goes UP, is the entity Safer or Riskier? UPSC loves inverting this relationship (as seen in Statement 3).
Concept hooks from this question
📌 Adjacent topic to master
S1
👉 Interest Coverage Ratio (ICR)
💡 The insight

ICR measures a firm's ability to meet interest payments and is used to classify firms (for example, identifying 'zombie' firms) based on debt-service capacity.

High-yield: central to questions on firm solvency, corporate debt, and banking credit assessment. Connects to non-performing assets and default risk analysis, enabling evaluation-style answers on how banks judge borrower quality.

📚 Reading List :
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 16: Terminology > 16 Terminology > p. 463
🔗 Anchor: "Does the Interest Coverage Ratio of a firm in India help banks assess the firm's..."
📌 Adjacent topic to master
S1
👉 Credit assessment and pricing in bank lending (credit risk premium)
💡 The insight

Banks adjust loan spreads through a credit risk premium when a borrower's assessed creditworthiness changes, linking assessment to loan pricing.

High-yield: underpins MCLR and interest-rate questions, linking bank lending policy to borrower-specific risk. Helps answer why interest rates vary by borrower and how bank credit evaluation affects transmission of rates.

📚 Reading List :
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > MCLR > p. 92
🔗 Anchor: "Does the Interest Coverage Ratio of a firm in India help banks assess the firm's..."
📌 Adjacent topic to master
S1
👉 Leverage ratio and debt-servicing indicators
💡 The insight

Leverage ratio (debt vs equity) complements ICR to indicate overall credit risk and a firm's ability to service debt.

High-yield: connects corporate finance metrics to bank lending decisions and systemic risk. Useful for questions on balance-sheet analysis, creditworthiness, and probability of default.

📚 Reading List :
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 16: Terminology > 16 Terminology > p. 457
🔗 Anchor: "Does the Interest Coverage Ratio of a firm in India help banks assess the firm's..."
📌 Adjacent topic to master
S2
👉 Interest Coverage Ratio (ICR) and firm distress
💡 The insight

ICR measures a firm's earnings relative to interest expense and identifies firms that cannot cover interest from income.

High-yield concept for questions on corporate solvency, NPAs and credit risk; links firm-level financial health to lending decisions and default risk analysis. Mastering it enables candidates to explain borrower assessment and classify distressed firms.

📚 Reading List :
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 16: Terminology > 16 Terminology > p. 463
🔗 Anchor: "Does the Interest Coverage Ratio of a firm in India help banks evaluate the firm..."
📌 Adjacent topic to master
S2
👉 Banks' credit assessment and credit risk premium
💡 The insight

Banks change the credit-risk component of loan spreads only when a borrower's credit assessment shifts substantially.

Key for understanding how banks price loans and react to changes in borrower risk; connects monetary policy, lending rates (MCLR/external benchmark) and bank risk management — useful for policy and banking questions.

📚 Reading List :
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > MCLR > p. 92
🔗 Anchor: "Does the Interest Coverage Ratio of a firm in India help banks evaluate the firm..."
📌 Adjacent topic to master
S2
👉 Use of financial ratios (leverage, CRAR) to summarise risk
💡 The insight

Ratios such as leverage and capital-to-risk-weighted-assets condense balance-sheet information into measures of indebtedness and safety for lenders and regulators.

Covers foundational tools used across banking, corporate finance and regulation topics; helps answer questions on depositor safety, loan evaluation and systemic risk by linking micro (firm) and macro (bank/regulatory) perspectives.

📚 Reading List :
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 16: Terminology > 16 Terminology > p. 457
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > 2 Money and Banking- Part I > p. 94
🔗 Anchor: "Does the Interest Coverage Ratio of a firm in India help banks evaluate the firm..."
📌 Adjacent topic to master
S3
👉 Interest Coverage Ratio (ICR): interpretation
💡 The insight

ICR is the ratio of a firm's profit (after tax) to its interest expense and is used to assess a firm's ability to cover interest payments.

High-yield for corporate finance and banking questions: mastering ICR helps assess creditworthiness, informs lending decisions and links to topics on firm solvency and financial stability. It enables quick judgments on statements about debt-servicing capacity and comparative risk across firms.

📚 Reading List :
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 16: Terminology > 16 Terminology > p. 463
🔗 Anchor: "Does a higher Interest Coverage Ratio for a borrowing firm in India indicate a w..."
🌑 The Hidden Trap

Debt Service Coverage Ratio (DSCR). While ICR only looks at interest payments, DSCR looks at Interest + Principal Repayments. A firm might have good ICR but poor DSCR if it has huge principal maturities due. This is the 'Next Logical Question' for corporate insolvency.

⚡ Elimination Cheat Code

The 'Linguistic Literal' Hack. Look at the words 'Interest Coverage'. If your coverage is 'Higher', you are obviously 'Better' protected. Statement 3 says 'Higher Coverage = Worse ability'. This is a direct linguistic contradiction. Eliminate Statement 3, and you are left with Option A (1 and 2) immediately.

🔗 Mains Connection

Mains GS-3 (Investment Models & Growth): Link ICR to the 'Chakravyuh Challenge' (Economic Survey). Firms with consistently low ICR (Zombies) hog credit and resources, preventing 'Creative Destruction,' which drags down national productivity and GDP growth.

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