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Fixed Charge Coverage Ratio – Definition – Calculation – Example

What Is the Fixed-Charge Coverage Ratio?

Fixed Charge Coverage RatioThe Fixed Charge Coverage Ratio measures a firm’s ability to pay its fixed charges or expenses with the income it generates before interest and income taxes.

Fixed charges are business expenses that occur on a regular basis.  They are independent of the volume of business. Fixed charge is a term for a variety of expenses, including principal and interest payments for a loan, insurance, taxes, utilities, salaries, rent, and lease payments. This should not be confused with variable expenses that are dependent on the volume of business.

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. If you can’t meet these expenses, you’re not likely to remain in business for long.

How do you calculate the fixed charge coverage ratio?

FCCR = (EBIT + Fixed Charges Before Taxes) / (Fixed Charges Before Taxes + I)

  • FCCR – Fixed Charge Coverage Ratio
  • EBIT – Earnings before interest and taxes.  It is calculated by taking the total annual revenue and subtracting the cost of goods sold (COGS) and operating expenses.
  • – Interest expenses. Interest can be calculated by multiplying the total dollar amount of outstanding debt by the interest rate on the debt. It should also appear on your profit and loss statement.
The fixedcharge coverage ratio adds lease payments to earnings before income and taxes (EBIT).  These figures come from the company’s income statement.  Next, it adds back interest expense, lease expense, and other fixed charges. Finally, the adjusted EBIT is divided by the number of fixed charges plus interest. A ratio result of 1.5, for example, shows that a company can pay its fixed charges and interest.  In other words, there are 50% more earnings available to meet fixed charges.

Fixed Charge Coverage Ratio Example

For Example, Sight-4-Sore Eyes Co shows an EBIT of $250,000. The sum of its fixed charges before taxes, mostly lease payments, is $125,000. Also, there are interest expenses of $25,000. The fixed charge coverage ratio is then calculated as $250,000 plus $125,000, or $375,000, divided by $125,000 plus $25,000, or $150,000.  This results in a ratio of 2.5:1.   It means the optical company’s income is two-and-a-half times greater than its fixed costs.

Higher fixed cost ratios indicate that a business is healthy and further investment or loans are less risky. Lower ratios indicate weakness and an income insufficient to meet the business’ monthly bills. Obviously, the higher the ratio, the better.

What Does the Fixed-Charge Coverage Ratio Tell You?

The fixed-charge ratio is used by lenders.  They use it to analyze the amount of cash flow a company has available for debt repayment. A low ratio often predicts potential difficulty to make payments on fixed charges.  This is a scenario lenders try to avoid.  It introduces a greater risk that they will not be paid back. To avoid this risk, many lenders use coverage ratios to determine a company’s ability to pay for additional debt. Other ratios include including the times-interest-earned ratio (TIE) and the fixed-charge coverage ratio.  A company that can cover its fixed charges at a faster rate than its competitors is more efficient and likely, more profitable. Banks view this as a company that wants to borrow to finance growth rather than just keep up with its debts.

Analysis

The income statement shows a company’s sales and the costs related to those sales and operations. Some costs are variable costs that depend 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 like equipment lease payments, insurance payments, and installment payments on existing debt.

The fixed charge coverage ratio shows investors and creditors a firm’s ability to make its fixed payments. Like the Times Interest Earned Ratio (TIE), the FCCR is stated in numbers rather than percentages. The ratio measures how many times a firm can pay its fixed costs with its income before interest and taxes. In other words, it shows how many times greater the firm’s income is compared with its fixed costs.

Ultimately, this ratio can be viewed as a solvency ratio.  This is because it shows how readily a company can pay its bills when they become due. Obviously, if a company can’t pay its lease or rent payments, it will not be in business very long. Higher fixed cost ratios indicate a healthier and less risky business to lend or invest in. Lower ratios show creditors and investors that the company may eventually face difficulty paying its monthly bills.

Fixed Charge Coverage Ratio vs Times Interest Earned (TIE)

The reason for calculating 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.  The FCCR considers additional fixed charges, including lease expenses, into the equation. 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.

Fixed Charge Coverage Ratio vs Debt Service Coverage Ratio

The main difference between the fixed charge coverage ratio and the debt service coverage ratio depends on focus. Whether the goal is the ability of the company to settle fixed charges or to determine the funds available to meet the debt obligations. Both these ratios provide an indication of the level of gearing in the company.  As such, they are important ratios for determining solvency. If these ratios are lower than an acceptable level, additional sources of finance will have to be considered.

  • Fixed charge coverage ratio – assesses the ability of a company to pay off outstanding fixed expenses including interest and lease expenses.
  • Debt service coverage ratio measures the amount of cash available to meet the.  

What is Considered a Good Ratio?

Most lenders expect to see a fixed charge coverage ratio of 1.25:1.  Therefore, a good fixed charge coverage ratio should be at least equal to or greater than 1.25:1. A ratio that is 1:1 or lower is a cause for concern.  It means your business is barely making enough money to cover your fixed charges. A ratio below 1.25 indicates that you may currently be able to cover every debt.  However, you do not have a large cushion to fall back on. If the business goes through a downturn and revenue drops, you might quickly have to dip into cash reserves.

FCCR Limitations 

For new and rapidly growing companies, the FCCR doesn’t allow for rapid changes in the amount of capital required. The ratio 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 for a loan, they typically look at several other benchmarks.  A single ratio is simply not enough information to get a complete view of any company’s financial condition.

Up Next: Per Stirpes – What Does it Mean?

Per Stirpes

Per Stirpes, used in a will stipulates how assets are to transfer if beneficiaries pass away before you do. It passes their share to their heirs.

Per stirpes is a designation that instructs where and how your assets should be passed down in the event a beneficiary passes away before you do. For example, if a beneficiary dies before you do, their share of your estate will automatically and evenly go to their child or children.  Many will stipulate that the estate is to be distributed per stirpes.  In that case, if a beneficiary dies, each named, living beneficiary receives their original portion of the estate. Any heirs of the deceased beneficiary split that portion of the inheritance equally.

The term per stirpes is commonly used to refer to an individual’s assets under a will.  However, it is sometimes used in individual retirement accounts (IRAs) to designate the beneficiaries.

Per stirpes and per capita are similar, but there are differences. Per stirpes in Latin means by branch.  In this case, that a portion of the will must go to a person or that person’s heirs. Per capita means by the head.  Therefore, any surviving descendants of the same generation distribute property equally, by headcount.

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