Credit Risk Management Practice Exam

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What is the debt service coverage ratio (DSCR) used for in finance?

To assess a borrower's ability to repay loans
To calculate the interest payment on bonds
To determine the cost of debt financing
To measure liquidity in investment portfolios

The correct answer is: To assess a borrower's ability to repay loans

The debt service coverage ratio (DSCR) is primarily utilized to assess a borrower's ability to repay loans. This ratio compares an entity's cash flow available for debt servicing to its obligations, which include both principal and interest payments. A higher DSCR indicates that the borrower generates sufficient earnings to cover its debt commitments, thus suggesting lower credit risk and a greater capability to meet financial obligations. Institutions often examine this ratio when evaluating loan applications to ensure that borrowers will be able to meet their debt obligations without financial strain. The other options, while relevant to different aspects of finance, do not directly pertain to the specific function of the DSCR. For example, calculating interest payments on bonds and determining the cost of debt financing are financial calculations that focus more on pricing and returns rather than evaluating repayment capacity. Similarly, measuring liquidity in investment portfolios pertains to the availability of cash and liquid assets to cover short-term obligations, which is separate from the assessment of long-term debt servicing capacity that the DSCR provides.