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FRM Part II · FRM Exam Part II · Distress Symptoms and Remedies

A firm has EBIT of 40 million, interest expense of 50 million, and 30 million of scheduled principal repayments due this year. It holds 20 million of cash. Which statement best describes its position?

Interest coverage is EBIT divided by interest, 40/50 = 0.8, below one, so operations cannot cover interest. With 80 million of total debt service against 60 million of EBIT plus cash, the one-off cash buffer cannot solve the problem, signalling financial distress.

  1. AEBIT covers interest 1.25 times, so it is not distressed
  2. BInterest coverage is 0.8, so operating earnings do not cover interest, signalling distress that the cash balance cannot cure over timeCorrect
  3. CInterest coverage is 1.25, but principal repayments are irrelevant to distress
  4. DInterest coverage is 0.8, which is a sign of strength because cash exceeds half of interest

Explanation

Coverage is 40/50 = 0.8, below 1, so operations do not cover interest. Total debt service is 80 million versus 40 million EBIT plus 20 million cash, so a 20 million gap remains even before considering that cash is a one-time buffer. Option A inverts the ratio.

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