Certified Financial Management Specialist Practice Exam

What does interest coverage measure in financial management?

1. The ability to pay interest expenses from earnings

2. Gross profit margin of the company

3. The overall profitability of a firm

4. Net asset value

The correct answer is: The ability to pay interest expenses from earnings

Interest coverage measures a company's ability to pay interest expenses on outstanding debt using its earnings. This is typically calculated by taking earnings before interest and taxes (EBIT) and dividing it by the interest expense. A higher interest coverage ratio indicates that the company generates sufficient income to cover its interest obligations, making it less risky for lenders and investors. This ratio is critically important for creditors and investors as it provides insight into the financial stability of the company. If a firm's interest coverage ratio is low, it may suggest that the company is struggling to generate enough earnings to meet its debt obligations, which could indicate potential financial distress. On the other hand, a high ratio suggests a strong capacity to pay interest, which reflects positively on the company's financial health and may bolster investor confidence. In contrast, the other options focus on different aspects of financial performance. The gross profit margin relates specifically to sales and production costs. Overall profitability considers net income relative to revenues or investments, while net asset value pertains to the total value of the company’s assets minus its liabilities. These metrics help assess different dimensions of a company’s financial position, but they do not specifically quantify the ability to manage interest expenses as interest coverage does.