The number of times earnings before interest and taxes of a company covers the interest obligation is indicated by which ratio?

Interest Coverage Ratio

The correct answer is option 2- Interest Coverage Ratio.

The number of times earnings before interest and taxes of a company covers the interest obligation is indicated by Interest Coverage Ratio.

The interest coverage ratio refers to the number of times earnings before interest and taxes of a company covers the interest obligation. This may be calculated as follows:
ICR = EBIT/Interest.

The higher the ratio, lower shall be the risk of company failing to meet its interest payment obligations. However, this ratio is not an adequate measure. A firm may have a high EBIT but low cash balance. Apart from interest, repayment obligations are also relevant.

OTHER OPTIONS

• 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. A higher DSCR indicates better ability to meet cash commitments and consequently, the company’s potential to increase debt component in its capital structure.

• Return on Investment (RoI): if the RoI of the company is higher, it can choose to use trading on equity to increase its EPS, i.e., its ability to use debt is greater. RoI is an important determinant of the company’s ability to use Trading on equity and thus the capital structure.

• Cost of debt: A firm’s ability to borrow at a lower rate increases its capacity to employ higher debt. Thus, more debt can be used if debt can be raised at a lower rate.