Chartered Financial Analyst (CFA) Level 1 Practice Exam

How is debt coverage calculated?

1. CFO / total debt

2. CFO / total liabilities

3. CFO / total equity

4. CFO / current debt

The correct answer is: CFO / total debt

Debt coverage is typically calculated using the formula where CFO, or Cash Flow from Operations, is divided by total debt. This calculation provides a measure of a company's ability to cover its debt obligations with the cash generated from its operational activities. A higher ratio indicates better financial health and suggests that a company can comfortably service its debt, while a lower ratio might signal potential financial difficulties. Using CFO in this calculation is advantageous because it reflects the actual cash generated from the company's core business operations, providing a clearer picture of liquidity compared to other financial metrics that might include non-cash items. Consequently, it emphasizes the operational efficiency of the company in relation to its funding requirements. In contrast, other options involve ratios that do not specifically focus on the relationship between cash flows and the company’s debt obligations. For example, dividing CFO by total liabilities or total equity wouldn't specifically provide insights into the company's ability to handle debt payments. Instead, those ratios might be more reflective of overall leverage or equity financing rather than debt servicing capabilities. Similarly, dividing by current debt would limit the analysis to short-term obligations only, not accounting for the full spectrum of the company's long-term debt responsibilities.