Chartered Financial Analyst (CFA) Level 1 Practice Exam

Which formula represents FFO (Funds from operations) interest coverage?

1. (FFO + interest paid - operating lease adjustments) / Gross interest

2. FFO / Total debt

3. CFO(adjusted) - Capital expenditures / Total Debt

4. EBIT / Average Total Capital

The correct answer is: (FFO + interest paid - operating lease adjustments) / Gross interest

The formula representing FFO (Funds from Operations) interest coverage is given by: (FFO + interest paid - operating lease adjustments) / Gross interest. This formula is designed to assess an entity's ability to cover its interest expenses through funds generated from operations. In this context, FFO serves as a measure of cash flow that focuses specifically on the cash generated by a company's core operations, excluding the effects of capital structure and financing activities. By adjusting the FFO to include interest paid and exclude operating lease costs, this formula provides a more accurate representation of the cash available to meet interest obligations. Interest coverage ratios are critical for evaluating a company's financial health, particularly in showing how well a company's earnings can cover its interest expenses. A higher ratio indicates better ability to meet interest payments, which can be reassuring to creditors and investors alike. The other formulas do not focus specifically on measuring the relationship between funds from operations and interest expenses, making them less relevant for assessing interest coverage. For example, FFO / Total Debt examines overall leverage rather than the specific ability to cover interest payments, while EBIT / Average Total Capital focuses on profitability relative to total capital rather than cash flow management concerning debt service.