What is the coverage ratio for fixed charges?
The fixed-charge coverage ratio (FCCR) assesses a company’s capacity to cover fixed expenses such as debt payments, interest, and equipment leases. It indicates a company’s profit coverage of fixed costs. Banks use this percentage to decide whether to lend to a firm.
Calculating Fixed-Charge Coverage Ratio
To assess a company’s capacity to cover fixed costs, start with EBIT from its income statement and add back interest expenditure, leasing expense, and other fixed charges.
The next step is to divide adjusted EBIT by interest plus fixed charges. A 1.5 ratio means a corporation can pay its fixed expenses and claim 1.5 times its earnings.
Fixed-charge Coverage Ratio: What Does It Tell You?
Lenders use the fixed-charge ratio to assess a company’s debt-repayment cash flow. A low ratio signals an inability to pay fixed costs, which lenders aim to avoid since it raises the risk of non-payment.
Lenders utilize coverage ratios, such as the times-interest-earned ratio (TIE) and the coverage ratio, to assess a company’s capacity to handle increased debt and mitigate risk. A corporation that covers its fixed charges faster than its competitors is more efficient and lucrative. This corporation wants to borrow for expansion, not survival.
The income statement displays a company’s revenues and corresponding costs. Some expenses are changeable and based on sales volume over time. Variable expenses rise with sales. Other costs are set and must be paid regardless of economic activity. Fixed expenses may include equipment leases, insurance, debt installments, and preferred dividends.
Example of Fixed-Charge Coverage Ratio in Use
The fixed-charge coverage ratio measures how efficiently earnings cover fixed charges. While similar to the TIE ratio, this conservative estimate considers fixed expenditures, such as lease expenses.
The fixed-charge coverage ratio differs from the TIE but can be interpreted similarly. To calculate the fixed-charge coverage ratio, add lease payments to EBIT and divide by total interest and leasing expenditures.
Suppose Company A has $300,000 in EBIT, $200,000 in lease payments, and a $50,000 interest charge. $300,000 + $200,000 divided by $50,000 plus $200,000 yields $500,000 split by $250,000, or 2x fixed-charge coverage.
The company’s earnings are double its fixed costs, which is poor. The company’s future payments are in danger because it can only pay the fixed costs twice with its revenues. A more excellent ratio is desirable.
Like the TIE, a more excellent FCCR ratio is desirable.
Limitations of Fixed-Charge Coverage Ratio
The FCCR ignores quick capital fluctuations for young and developing enterprises. The model also ignores earnings for owner’s draws and investor dividends. These occurrences influence ratio inputs and can lead to a false conclusion without other measures.
To assess a company’s creditworthiness for a loan, banks often use additional benchmarks beyond the fixed-charge coverage ratio to acquire a more complete financial picture.
Conclusion
- The coverage ratio (FCCR) measures a company’s ability to cover rent, utilities, and debt with earnings.
- Lenders typically use the coverage ratio to assess a company’s creditworthiness.
- A high FCCR ratio means a corporation can pay fixed charges with current earnings.
