On the basis of the passage given below, Answer the questions.
Aval Ltd. is engaged in the business of the export of canvas goods and bags. In the past, the performance of the company was above expectations. In line with the latest demand in the market, the company decided to venture into leather goods for which it required specialized machinery. For this, the Finance Manager Prabhu prepared a financial blueprint for the organization's future operations to estimate the amount of funds required and the timings with the objective to ensure that enough funds are available at the right time. He also collected the relevant data about the profit estimates for the coming years. By doing this, he wanted to be sure about the availability of funds from the internal sources of the business. For the remaining funds, he is trying to find alternative sources from outside. The company is willing to go for a public issue of shares and debentures to be made under SEBI guidelines. Public issue of shares and debentures requires considerable outlay of funds too. Due to extensive operations, the manager is of the viewpoint that a company may have to ensure that earnings before interest and taxes of a company should cover the interest obligation. The manager also felt that the cash profits generated by the operations need to be compared with the total cash required for the service of the debentures and the preference share capital.
"Due to extensive operations, the manager is of the viewpoint that a company may have to ensure that earnings before interest and taxes of a company should cover the interest obligation". Identify the factor affecting capital structure highlighted in the aforesaid statement.
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → Interest Coverage Ratio
Option (1) Cash Flow Position — Incorrect. This factor looks at the size of future cash flows before borrowing. The statement is about EBIT and interest, not about cash flows.
Option (2) Interest Coverage Ratio — Correct. The passage says EBIT “should cover the interest obligation”. The interest coverage ratio is the number of times earnings before interest and taxes (EBIT) of a company covers the interest obligation. The higher the ratio, the lower the risk that the company fails to pay its interest.
Option (3) Debt Service Coverage Ratio — Incorrect. DSCR compares cash profits with the cash needed for debt and preference share capital. That is the next line of the passage, not this one.
Option (4) Tax rate — Incorrect. The tax rate affects the cost of debt, because interest is a deductible expense. The statement does not mention tax.
Note: The passage is based on a case study given in the exercises of the NCERT chapter Financial Management, with some lines added. NCERT (2026-27 Edition): “Cash Flow Position: Size of projected cash flows must be considered before borrowing. Cash flows must not only cover fixed cash payment obligations but there must be sufficient buffer also. …” “Interest Coverage Ratio (ICR): The interest coverage ratio refers to the number of times earnings before interest and taxes of a company covers the interest obligation. …” “Debt Service Coverage Ratio (DSCR): Debt Service Coverage Ratio takes care of the deficiencies referred to in the Interest Coverage Ratio (ICR). The cash profits generated by the operations are compared with the total cash required for the service of the debt and the preference share capital. …” “Tax Rate: Since interest is a deductible expense, cost of debt is affected by the tax rate. …” |