Chartered Financial Analyst (CFA) Level 1 Practice Exam

In calculating the EBIT interest coverage, which components are included?

1. Gross interest and depreciation

2. Net income and operating expenses

3. EBIT and Gross interest

4. EBITDA and total capital

The correct answer is: EBIT and Gross interest

The EBIT interest coverage ratio assesses a company's ability to pay interest on its outstanding debt, which is a critical measure of financial health. This ratio is calculated by dividing Earnings Before Interest and Taxes (EBIT) by the company's interest expenses. In this context, EBIT represents the company’s profitability from its operations without accounting for interest payments or income taxes; it is a critical starting point for determining how much earnings are available to cover interest expenses. Gross interest, which refers to the total interest expense incurred, is the denominator in this calculation. Thus, the combination of EBIT and gross interest allows for a direct assessment of how many times the company can cover its interest obligations with its operating earnings. This makes the choice that includes EBIT and gross interest the right one, as it directly reflects the components necessary to evaluate the firm's capacity to meet its interest expenses. The other choices do not provide the correct components needed for calculating this specific ratio, as they may involve figures unrelated to directly assessing interest coverage or use incompatible financial metrics.