Fixed-Charge Coverage Ratio

What Is the Fixed-Charge Coverage Ratio?

The fixed-charge coverage ratio (FCCR) measures a firm's ability to cover its fixed charges, such as debt payments, interest expense, and equipment lease expense. It shows how well a company's earnings can cover its fixed expenses. Banks will often look at this ratio when evaluating whether to lend money to a business.

The Formula for the Fixed-Charge Coverage Ratio Is:

F C C R = E B I T + F C B T F C B T + i where: E B I T = earnings before interest and taxes F C B T = fixed charges before tax i = interest \begin{aligned} &FCCR = \frac{EBIT + FCBT}{FCBT + i} \\ &\textbf{where:}\\ &EBIT=\text{earnings before interest and taxes}\\ &FCBT=\text{fixed charges before tax}\\ &i=\text{interest}\\ \end{aligned} FCCR=FCBT+iEBIT+FCBTwhere:EBIT=earnings before interest and taxesFCBT=fixed charges before taxi=interest

How to Calculate the Fixed-Charge Coverage Ratio

The calculation for determining a company's ability to cover its fixed charges starts with earnings before interest and taxes (EBIT) from the company's income statement and then adds back interest expense, lease expense, and other fixed charges.

Next, the adjusted EBIT is divided by the amount of fixed charges plus interest. A ratio result of 1.5, for example, shows that a company can pay its fixed charges and interest 1.5 times out of earnings.

What Does the Fixed-Charge Coverage Ratio Tell You?

The fixed-charge ratio is used by lenders looking to analyze the amount of cash flow a company has available for debt repayment. A low ratio often reveals a lack of ability to make payments on fixed charges, a scenario lenders try to avoid since it increases the risk that they will not be paid back.

To avoid this risk, many lenders use coverage ratios, including the times-interest-earned ratio (TIE) and the fixed-charge coverage ratio, to determine a company's ability to take on and pay for additional debt. A company that can cover its fixed charges at a faster rate than its peers is not only more efficient but more profitable. This is a company that wants to borrow to finance growth rather than to get through a hardship.

A company's sales and the costs related to its sales and operations make up the information shown on its income statement. Some costs are variable costs and dependent on the volume of sales over a particular time period. As sales increase, so do the variable costs. Other costs are fixed and must be paid regardless of whether or not the business has activity. These fixed costs can include items such as equipment lease payments, insurance payments, installment payments on existing debt, and preferred dividend payments.

Example of the Fixed-Charge Coverage Ratio in Use

The goal of computing the fixed-charge coverage ratio is to see how well earnings can cover fixed charges. This ratio is a lot like the TIE ratio, but it is a more conservative measure, taking additional fixed charges, including lease expenses, into consideration.

The fixed-charge coverage ratio is slightly different from the TIE, though the same interpretation can be applied. The fixed-charge coverage ratio adds lease payments to earnings before income and taxes (EBIT) and then divides by the total interest and lease expenses.

Let's say Company A records EBIT of $300,000, lease payments of $200,000, and $50,000 in interest expense. The calculation is $300,000 plus $200,000 divided by $50,000 plus $200,000, which is $500,000 divided by $250,000, or a fixed-charge coverage ratio of 2x.

The company's earnings are two times greater than its fixed costs, which is considered low. That's because the company would only be able to pay the fixed charges twice with the earnings it has, increasing the risk that it cannot make future payments. The higher this ratio is, the better.

Like the TIE, the higher the FCCR ratio, the better.

Limitations of the Fixed-Charge Coverage Ratio

The FCCR doesn't consider rapid changes in the amount of capital for new and growing companies. The formula also doesn't consider the effects of funds taken out of earnings to pay an owner's draw or pay dividends to investors. These events affect the ratio inputs and can give a misleading conclusion unless other metrics are also considered.

For this reason, when banks evaluate a company's creditworthiness for a loan, they typically look at several other benchmarks in addition to the fixed-charge coverage ratio in order to gain a more complete view of the company's financial condition.