Fixed Charge Coverage RatioDefined with Examples & Formula

Written By:
Lisa Borga

The fixed-charge coverage ratio (FCCR) is a measure of a company’s ability to meet its fixed charges.

These charges include common examples such as repayment of debt, rent, and lease of equipment.

This ratio provides an indication of a firm’s ability to handle its fixed expenses and, as a result, will frequently be looked at by banks as a factor in deciding on whether to issue a loan to a company.

Understanding the Fixed-Charge Coverage Ratio

First of all the formula for the fixed-charge coverage ratio is:

Fixed-Charge Coverage Ratio = (Earnings Before Interest & Taxes + Fixed Charges Before Taxes) / (Fixed Charges Before Taxes + Interest)

Calculating the fixed-charge coverage ratio of a company starts with finding its earnings before interest and taxes (EBIT), which can be found on its income statement.

Next, all of the company’s fixed charges before taxes (FCBT), such as interest and lease expenses, will be added on.

Following this, the now adjusted EBIT will be divided by the company’s (FCBT) plus interest.

The resulting number will indicate the company’s ability to cover its fixed charges.

For example, if a company possessed a ratio of 2, this would indicate that its earnings would pay for its fixed expenses and interest two times.

What Information Is Provided by the Fixed-Charge Ratio?

The FCCR shows the number of times in a year in which a company can cover its fixed charges.

This is a key indicator of solvency which lenders will often look at in addition to the times-interest-earned ratio (TIE).

This is because a low ratio indicates that a business may struggle to repay its fixed charges.

In addition to showing how likely a company is to pay its fixed expenses, a higher ratio may indicate that it is more likely to use a loan to fuel growth rather than to cover its current expenses.

This is likely to be a more profitable company that is likely to be able to repay such a loan.

A business’s income statement will show its sales as well as any costs associated with its sales and operations.

Some of these costs will vary in proportion to a business’s production or sales volume, and these are variable costs.

Whereas other costs will be the same regardless of the volume of sales or other business activity, and these are fixed costs.

Fixed costs may include mortgage payments, property taxes, depreciation, and lease payments.

Fixed-Charge Coverage Ratio Example

Generally, a business calculates the FCCR to find out if its earnings can be used to pay its fixed charges and, if so, how well.

The FCCR is quite similar to the times-interest-earned ratio.

However, it tends to be more conservative.

It includes more fixed charges and it also includes lease expenses.

This makes the FCCR ratio a bit different than the TIE ratio, but the same basic explanation can be used.

The fixed-charge coverage ratio takes a business’s earnings before income and taxes and adds lease payments to this.

Once this is done, the total is divided by the lease expenses and interest added together.

For example, if Business C had an EBIT of $700,000, $100,000 in interest expense, and $200,000 in lease payments, the fixed-charge coverage ratio would be calculated by adding the $700,000 and the $200,000 together and dividing this by $200,000 plus $100,000.

This would mean a fixed-charge coverage ratio of 3.

An FCCR of three means that Business C has earnings that are three times its fixed charges.

Therefore, the company could pay its fixed charges three times with its earnings.

A higher FCCR is better as it means there is less risk of being unable to make payments in the future.

This is similar to the TIE ratio, which is also better when it is higher.

Fixed-Charge Coverage Ratio Limitations

The fixed-charge coverage ratio does not take into account the frequent changes in the amount of capital a new or growing company will have.

This ratio also fails to consider the results of an owner removing money from the business or a company paying dividends.

These transactions will affect the inputs used in the ratio, and if other benchmarks are not used in addition to the FCCR, the ratio could give an investor an inaccurate view of the business.

Therefore, banks consider a number of benchmarks along with the fixed-charge coverage ratio when considering a business’s creditworthiness for a loan to give them a better idea of the financial condition of the business.

Key Highlights

• The fixed-charge coverage ratio shows the ability of a company’s earnings to cover its fixed expenses.
• Banks will often check a company’s fixed-charge coverage ratio in judging whether or not to issue a loan.
• A low FFCR ratio shows that a business may struggle to cover its fixed charges with its present earnings.