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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.

Which financial ratio will establish the relation between the cash profits generated by the operations and the total cash required for the service of the debentures and the preference share capital?

Solution

✅ Correct Option: 2

Option 1 -> Interest Coverage Ratio measures only the ability to pay interest expenses on debt, but does not consider preference share dividends or principal repayments.

Option 2 -> Debt Service Coverage Ratio measures the cash flow available from operations to service total debt obligations including debenture payments (interest + principal) and preference share dividends.

Option 3 -> Return on Investment measures the overall profitability of investments relative to their cost, not specifically the debt servicing capacity.

Option 4 -> Return on Equity measures profitability relative to shareholders' equity, not the ability to service debt and preference capital.


Hence, Option 2: Debt Service Coverage Ratio -> This ratio specifically establishes the relationship between cash profits generated by operations and the total cash required for servicing both debentures (debt obligations) and preference share capital (dividends). It comprehensively covers all fixed financial obligations that need to be paid from operating cash flows -> correct

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