Context

  • The Reserve Bank of India recently asked banks to review various financial parameters of their borrowers, including interest coverage ratio, in order to frame an appropriate policy for making provisions for standard assets at a higher level than the rules require.

1.What is interest coverage ratio (ICR)?

  • It indicates the ability of a firm to service the debt and repay it over the tenure of the loan. It basically identifies how many times earnings can pay the interest required by existing debt. The interest coverage ratio is calculated by dividing a company’s earnings before interest and taxes by the company’s interest expenses for a given period.

2.Why do banks look at this ratio?

  • It is one of the parameters that help understand and evaluate present and emerging risks of a firm a bank is lending to. An analysis of interest coverage ratio, among other parameters, helps the banks assess the borrowers’ financial strength and ability to service a loan. The number of times interest is covered determines the viability of debt. Banks often insert terms in their legal documents (loan terms/note clauses) mandating a minimum coverage ratio for debt.

3.Why do regulators attach so much importance to ICR?

  • The banking sector is plagued with severe stressed assets and defaults that have impacted the sector’s profitability. The regulator want banks to be prudent in their assessment of future stress in their asset (loan) portfolio. The level of corporate leverage has emerged as an important parameter to determine potential stress that could be there in a loan. ICR is one of the important factors that indicate the possibility of stress in a bank’s loan book and the ability of the borrower to repay a loan.

    Interest Coverage Ratio
    Source: ET

4.Is there any ideal level of ICR?

  • The higher the level of ICR (in terms of a numeric) the better is the ability of a borrower to service its debt. But there is no magic single number that can be called an ideal level. It would depend on the state of the industry and business cycle, and vary from industry-to-industry. During good times, when sales revenues are buoyant, a lower ICR level may not be as bad as when revenues slow down.

5.Which are the sectors to watch?

  • Steel and telecom are among the worst hit sectors at present. These two sectors together account for a bulk of the banking sector stress and bad loans. Little wonder then that the RBI has advised banks to be cautious in lending to the companies in the telecom sector, which have an interest coverage ratio of less than 1.
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