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Given below are two statements:

Statement I: Interest coverage ratio indicates how many times fixed interest charges are earned, based on the earnings available to pay these expenses.

Statement II: One minus the reciprocal of interest coverage ratio indicates how far earnings could decline before it would be impossible to pay the interest charges from current earnings.

In the light of the above statements, choose the most appropriate answer from the options given below:

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UGC NET Paper 2: Management 29 Oct 2022 Shift 2
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  1. Both Statement I and Statement II are true
  2. Both Statement I and Statement II are false
  3. Statement I is true but Statement II is false
  4. Statement I is false but Statement II is true

Answer (Detailed Solution Below)

Option 1 : Both Statement I and Statement II are true
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The correct answer is Both Statement I and II are true

Key Points Interest coverage ratio: 

  • The interest coverage ratio is a debt and profitability ratio used to determine how easily a company can pay interest on its outstanding debt.

Statement I: The interest coverage ratio indicates how many times fixed interest charges are earned, based on the earnings available to pay these expenses.

  • The interest coverage ratio is a debt and profitability ratio used to determine how easily a company can pay interest on its outstanding debt. The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense during a given period.

Statement II: One minus the reciprocal of interest coverage ratio indicates how far earnings could decline before it would be impossible to pay the interest charges from current earnings.

  • The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense during a given period.
  • The formula used is: Interest Coverage Ratio= EBIT/Interest Expense
  • ​The lower the ratio, the more the company is burdened by debt expenses and the less capital it has to use in other ways. When a company's interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable.
  • Companies need to have more than enough earnings to cover interest payments in order to survive future, and perhaps unforeseeable, financial hardships that may arise. 

Hence, the correct answer is Statement I and Statement II are true.

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