Chartered Financial Analyst (CFA) Level 1 Practice Exam

What formula represents Interest Coverage?

1. EBIT + interest payments

2. EBIT / interest payments

3. EBIT - interest payments

4. Net income / interest payments

The correct answer is: EBIT / interest payments

The correct representation of Interest Coverage is EBIT divided by interest payments. This ratio indicates a company's ability to pay interest on its outstanding debt, demonstrating the firm's financial health. By using EBIT, which stands for Earnings Before Interest and Taxes, the formula reveals how much operating income is available to cover interest expenses. A higher Interest Coverage ratio suggests that the company can easily meet its interest obligations, indicating lower financial risk. Conversely, a lower ratio may signal potential difficulties in servicing debt, raising concerns about financial stability. The other options do not accurately represent the concept of Interest Coverage. For instance, adding interest payments to EBIT does not provide meaningful insight into coverage since it distorts the relationship between the income generated and the expenses incurred. Subtracting interest payments from EBIT fails to capture the actual ability to meet financial obligations. Using net income instead of EBIT can be misleading because net income already accounts for interest expenses, which reduces the clarity of the company’s capacity to handle additional interest liabilities.