ACCA Financial Management (F9) Certification Practice Exam

Which ratio is a measure of financial risk designed to show risks in terms of profit?

1. Debt service coverage ratio

2. Interest Coverage Ratio

3. Profit margin ratio

4. Expense ratio

The correct answer is: Interest Coverage Ratio

The Interest Coverage Ratio is a key financial metric that indicates a company's ability to pay interest on its outstanding debt. It is calculated by dividing a company’s earnings before interest and taxes (EBIT) by the interest expenses for the same period. This ratio is vital for assessing financial risk, particularly in terms of profit because it reflects how many times a company can cover its interest obligations with its earnings. A higher interest coverage ratio suggests that a company has sufficient earnings to comfortably meet its interest requirements, indicating lower financial risk. Conversely, a low ratio may hint at potential difficulties in meeting interest payments, which can be a red flag for lenders and investors regarding the company’s financial health. While the other ratios mentioned also provide useful financial insights, they do not specifically focus on the relationship between profitability and financial risk in the context of debt obligations like the Interest Coverage Ratio does. For example, the Debt Service Coverage Ratio encompasses total debt payment obligations, while the Profit Margin Ratio measures profitability as a percentage of sales, and the Expense Ratio evaluates the efficiency of expense management relative to revenue.