Chartered Financial Analyst (CFA) Level 1 Practice Exam

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Discretionary cash-flow-to-debt can be calculated using which equation?

[CFO - capital expenditures - Dividend paid] / Total Debt
EBITDA / average outstanding common shares
(FFO - Dividends) / Capital Expenditures
(CFO - preferred dividends) / weighted average number of common shares

The correct answer is: [CFO - capital expenditures - Dividend paid] / Total Debt

The calculation of discretionary cash-flow-to-debt is designed to assess the financial health of a company by determining how much cash flow is available after accounting for essential expenditures before measuring it against the company's total debt. The correct formula captures this idea effectively. Using the equation: [CFO - capital expenditures - Dividends paid] / Total Debt, we see that it begins with cash flow from operations (CFO), which represents the cash generated from the company's core business operations. From this, it deducts capital expenditures, which are necessary for maintaining or expanding the asset base, and dividends paid, which are distributions to shareholders. By subtracting these amounts from CFO, we arrive at the discretionary cash flow available for servicing debt. When this discretionary cash flow is compared to total debt, it provides actionable insight into the company's ability to meet its financing obligations. A higher ratio indicates a stronger capacity to cover debt with available cash flow, an essential factor for lenders and investors when evaluating risk. In contrast, the other options either measure different financial metrics or do not appropriately represent discretionary cash flow in relation to debt, making them unsuitable for answering this question.