Chartered Financial Analyst (CFA) Level 1 Practice Exam

What formula represents interest coverage?

1. (CFO + interest paid + taxes paid) / interest paid

2. CFO / interest expense

3. CFO + interest paid / total interest

4. (CFO - taxes paid) / interest paid

The correct answer is: (CFO + interest paid + taxes paid) / interest paid

The correct formula for interest coverage is derived from the ability of a company's earnings to cover its interest obligations. Interest coverage is generally calculated using earnings before interest and taxes (EBIT) over interest expenses, but in the context of cash flows, it can also involve cash flow from operations (CFO). Choice A encompasses this by adding cash flow from operations with interest paid and taxes paid, and then dividing by the interest paid. This reflects a comprehensive approach to assessing how well a company's cash flows can cover interest payments, incorporating operational performance and tax effects. The rationale behind this method is that it provides a more nuanced view of liquidity and cash flow availability relative to the company’s interest obligations. By including both taxes and interest effectively in the numerator, it reflects a broader earning capacity which is crucial to determining the company's financial health regarding its debt obligations. Choices that focus solely on cash flow from operations or omit relevant components fail to provide a full picture of the company's ability to meet interest payments. Hence, they do not accurately represent interest coverage in the context of comprehensive financial analysis.