Chartered Financial Analyst (CFA) Level 1 Practice Exam

How is the EBIT interest coverage ratio calculated?

1. EBITDA / Gross interest

2. EBIT / Gross interest

3. Net income / Total debt

4. Gross revenue / Total assets

The correct answer is: EBIT / Gross interest

The EBIT interest coverage ratio is a measure of a company's ability to meet its interest obligations from its operating income. This ratio provides insight into how easily a company can pay interest on outstanding debt. It is calculated by dividing earnings before interest and taxes (EBIT) by the gross interest expense. EBIT represents the company's earnings generated from its core operations, excluding expenses related to interest and taxes, which makes it a suitable metric to evaluate operational efficiency before financial and tax considerations. By using gross interest in the denominator, this ratio focuses specifically on interest payments without accounting for any financial structural complexities. This ratio is crucial for investors and creditors as it indicates financial stability and the risk level associated with the company's debt. A higher EBIT interest coverage ratio suggests a greater ability to cover interest obligations, indicating a lower risk of default. The other options do not accurately reflect this specific measure: - EBITDA, while related, includes depreciation and amortization, which are not relevant in the context of net interest coverage. - Net income incorporates taxes and interest payments, making it misleading for assessing interest coverage because it reflects the aftermath of these expenses. - Gross revenue over total assets provides insight into asset efficiency or revenue generation but does not relate directly to interest expenses and therefore is unsuitable