The fixed-charge coverage ratio reflects a company’s capacity to pay for its fixed expenses, like debt, interest and lease. Banks and lenders usually consider this number when assessing a loan applicant’s creditworthiness.
A low ratio is understood as an indicator of declining earnings and generally poor fiscal health, which is unfavorable to creditors. Internally, a company can use this ratio to assess its fiscal health and to help decide on the feasibility of projects that can increase fixed costs and hence take the ratio down to a critical level.
Another financial metric often compared with the fixed-charge coverage ratio is the debt service coverage ratio, which is another important indicator of a company’s debt-to-capital-structure proportion. While both ratios have their similarities, they are essentially different in that the fixed-charge coverage ratio looks into a company’s capacity to cover its outstanding fixed charges, including interest and lease costs; while the debt service coverage ratio considers how much cash the company has to pay its debts.
Needless to say, it is crucial to differentiate between the two ratios properly as they can be quite close and confusing, although they are both important to a company that is trying to decide whether or not additional income streams should be considered.
Fixed-Charge Coverage Ratio Formula
$$FCCR = \dfrac{EBIT + Fixed\: Charges\: Before\: Tax}{Fixed\: Charges\: Before\: Tax + Interest}$$
Because the fixed-charge coverage ratio is not restricted to a single cost, this formula may be used regardless of how many fixed costs are involved.
A company’s financial statement reveals data on its sales and costs. Sometimes, costs are variable, which means they can change from time to time. Variable costs are also dependent on sales, so the more income a company makes, the more it spends in variable costs. Fixed costs, which are paid no matter how a company is performing, include equipment lease payments, debt payments, preferred dividends, etc.
The fixed-charge coverage ratio is calculated to determine how capable a company is of paying its fixed charges. This number is similar to the times interest earned ratio, except it is more conservative and includes other fixed charges (like lease expenses) in the calculation.
While the fixed-charge coverage ratio is bit unique from the TIE, it can be understood in the same way. The fixed-charge coverage ratio combines earnings before interest and taxes (EBIT) and FCBT payments before dividing the sum by FCBT plus interest.
Fixed-Charge Coverage Ratio Example
Creatov, a retailer of art supplies, is planning to improve its interior design and needs a loan to pay for the cost of the project. Before actually applying for a loan, Ed, the owner, wants to assess his own chances of being approved by the bank by reviewing his financial statement.
He finds the following numbers: earnings before interest and taxes is – $200,000; interest expense of $15,000; and fixed charges before tax- $24,000. What is Creatov’s fixed-charge coverage ratio?
Let’s break it down to identify the meaning and value of the different variables in this problem.
- Earnings Before Interest And Taxes: 200,000
- Fixed Charges Before Tax: 24,000
- Interest: 15,000
Now let’s use our formula:
$$FCCR = \dfrac{200{,}000 + 24{,}000}{24{,}000 + 15{,}000} = 5.74$$
In this case, Creatov’s fixed-charge coverage ratio would be 5.74.
This calculation makes it clear that Creatov is making 5.74 times more income than it is paying in interest and fixed costs. Ed now feels more relaxed, knowing that a ratio of 5.74 is a sign that he has a big chance of getting a bank loan.
Fixed-Charge Coverage Ratio Analysis
To determine whether or not a company can afford additional debt, creditors use many different coverage ratios, including the fixed-charge coverage ratio. If one company can pay for its expenses faster than the other company, it means the first company is more efficient and more profitable. It is also shows they aren’t afraid to take on debt in order to grow.
As with other financial metrics, the fixed-charge coverage ratio also has its limitations. For one, it does not consider abrupt capital increases or decreases in new and expanding companies, nor does it look into the effects of funds removed from earnings to cover investor dividends. Such a scenario can impact the final ratio and create an inaccurate picture.
Hence, when banks assess a company’s creditworthiness for a loan, they often consider other metrics besides the Fixed-Charge Coverage ratio, if only to widen their perspective of the company’s true fiscal position.
In the end, the goal is to control the ratio such that it keeps going higher or is at least maintain ed at industry averages by improving working capital management. A higher fixed-charge coverage ratio requires an increase in earnings without a considerable rise in costs. The trick is to pinpoint the expenses included in the fixed-cost coverage ratio computation and determine how to reduce them.
Another is to come up with a strategy that boosts sales while keeping cost to a minimum. A third option is to work out lower rental or lease rates with lessors, who will usually look into requests for reduced rent from long-time, good-paying lessees. Once lower lease rates are set, fixed charges can be reduced and the fixed-charge coverage ratio is improved.
Lastly, it’s not surprising for a company to wipe out its loan with a lower-interest loan . Investors can go over their loans and consolidate the more expensive ones, and then refinancing it through a new, less expensive loan. This will surely drive down interest expense, which, of course, impacts the fixed-charge coverage ratio.
Fixed-Charge Coverage Ratio Conclusion
- The fixed-charge coverage ratio shows a company’s ability to pay for its fixed charges with its earnings.
- This formula requires three variables: earnings before interest and taxes (EBIT), fixed charges before tax, and Interest.
- The fixed-charge coverage ratio is usually expressed as a whole number.
- This ratio is usually used by creditors when determining how credit-worthy a company is.
- The higher a company’s higher fixed-charge coverage ratio, the more capable it is of paying its fixed costs using its earnings.
Fixed-Charge Coverage Ratio Calculator
You can use the fixed-charge coverage ratio calculator below to quickly determine a company’s ability to cover its fixed charges with its income by entering the required numbers.