Chartered Financial Analyst (CFA) Level 1 Practice Exam

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Prepare for the CFA Level 1 Exam with comprehensive study guides. Access multiple choice questions and detailed explanations to enhance your readiness. Start your journey to become a Certified Financial Analyst today!

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What is the Fixed Charge Coverage formula?

(EBIT + Lease Payments) / (Interest Payments + Lease Payments)
(EBIT - Lease Payments) / (Interest Payments - Lease Payments)
EBIT + Interest Payments / Lease Payments
EBIT / (Interest Payments + Lease Payments)

The correct answer is: (EBIT + Lease Payments) / (Interest Payments + Lease Payments)

The Fixed Charge Coverage formula is a financial metric used to evaluate a company's ability to meet its fixed financial obligations, including interest and lease payments. The formula accentuates the importance of cash flow relative to these obligations, providing insight into the firm's financial health and ability to sustain operations without significant risk of default. The correct formula, which is represented by the chosen answer, is derived from the need to ascertain how many times a company's earnings before interest and taxes (EBIT), augmented by lease payments, can cover its total fixed charges (interest payments plus lease payments). By adding lease payments to EBIT, the formula captures the full scope of fixed financial commitments that the company faces. Subsequently, dividing this total by the sum of interest payments and lease payments establishes a coverage ratio that indicates the sufficiency of earnings to meet these obligations. This approach is incredibly valuable for investors and analysts as it provides a clear measure of the company's operational efficiency and financial stability concerning its fixed expenses. A ratio greater than one denotes that the firm can comfortably manage its obligations, while a ratio less than one highlights potential financial distress.