Question

Explain why a higher interest coverage ratio can also be a sign of weak financial management.

And reason that will lead to an increase in gross profit margin

Answer 1

Interest Coverage Ratio is used to determine the capacity of a company to pay interest on its outstanding Debt.

It is calculated by =

Its shows that how many time a Company can meet out the interest Liability out of its Earnings.

Ideally, the ICR should be 2, but if it is below 1.5 then the company is termed as a riskier Company to invest by the investor and questionable to meet out its liability.

Higher Ratio indicates the following things :

1. The company is not using its debts in an appropriate manner.

2. it may not be able to use to invest in new products, inventions, expansion, and markets.

3. It is too much concern about paying its interest on debts and playing in a safe zone is not good for the long term.

4. For a big company maintaining high debts and paying regular Interest, thereon is necessary not to maintain high ICR.

5. Debs creates a leverage effect for a company, high ICR means the company is not able to take advantage of its leverage position.

So, now it's clear that high ICR shows the weak financial management of the Company.

Reasons that will lead to an increase in Gross Profit Margin:

1. Reduce Direct Costs associated with the sale of the goods.

2 Increase the Revenue by enhancing the price of the goods ( Which is not a good idea) or by lowering the cost of production.

3. Optimum use of Inventory.

4. Optimum use of borrowed funds for manufacturing the goods/products.