Chartered Financial Analyst (CFA) Level 1 Practice Exam

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What does a low Interest Coverage ratio signify?

The company has high earnings relative to interest expenses
The company may struggle to meet interest payment obligations
The company is in a strong financial position
The company has low debt levels

The correct answer is: The company may struggle to meet interest payment obligations

A low Interest Coverage ratio indicates that a company may struggle to meet its interest payment obligations. This ratio, calculated as earnings before interest and taxes (EBIT) divided by interest expenses, assesses a company's ability to pay interest on its debt. When the ratio is low, it suggests that the company's earnings are insufficient to cover interest costs, which can raise concerns about its ability to service debt in the future. A high level of interest payments relative to earnings may lead to financial distress and could signal to investors and creditors that the company might have liquidity issues. Consequently, a low Interest Coverage ratio serves as a warning sign that the company is under financial pressure and may face potential solvency risks if economic conditions worsen or if its earnings do not improve.