Fixed Charge Coverage Ratio: Formula and How to
Calculate
The fixed
charge coverage ratio (FCCR) shows how well a business can pay its fixed
expenses, including mandatory debt payments and interest.
Lenders and
investors often use this metric to determine whether to approve a loan
application or invest in the business. Here’s what you need to know about the
fixed charge coverage ratio and how to calculate it.
What is the fixed charge coverage ratio?
The fixed
charge coverage ratio measures a company’s ability to meet fixed charges from
its earnings before interest and taxes (EBIT). Examples of fixed charges
include insurance premiums and lease and loan payments because
the same amount is due each month, no matter how much revenue the company
earns.
Essentially,
the FCCR shows how many times over your business can satisfy its predictable
financial responsibilities. An FCCR of 1 means you have just enough earnings
before interest and taxes to meet them. An FCCR of 2 shows you could pay them
all two times over.
The ideal
FCCR varies by industry, but many lenders look for borrowers to have a ratio of
at least 1.2.
How to calculate fixed charge coverage ratio
Here is the
fixed charge coverage ratio formula:
Fixed
charge coverage ratio formula =
(EBIT + fixed charges before taxes) / (fixed charges
before taxes + interest)
·
EBIT: earnings before taxes,
calculated by adding tax and interest expenses back to your net income
·
Fixed charges: Recurring
business expenses that are paid regardless of sales volumes, such as debt and
lease expenses
To
calculate your FCCR, add the company’s earnings before interest and taxes to
its fixed obligations before tax. Then divide that total by the sum of fixed
charges before tax plus interest.
The
resulting number represents how solvent your company is, with a higher number
(2 or above) indicating a healthier company with less financial risk.
Conversely, a ratio below 1 means you may have problems meeting your regular
financial obligations, and a sudden drop in earnings could be disastrous.
Fixed charge coverage ratio examples
Here are
two examples to help you better understand how to calculate your fixed charge
coverage ratio — one with a higher FCCR and one with a lower ratio.
Higher FCCR
Company A
has earnings before interest and taxes of $650,000. It pays $10,000 per month
for a building lease, $100,000 annually for equipment, $30,000
per year in principal payments towards loans and $80,000 annually in interest
payments.
Based on
the numbers below, here’s how Company A would calculate its FCCR.
·
EBIT: $650,000
·
Fixed charges before taxes:
·
Equipment expenses: $100,000
·
Annual lease: (monthly $10,000 x 12 months) = $120,000
·
Annual principal on a loan: $30,000
·
Annual interest payments: $80,000
With an
FCCR of 2.72, Company A could pay its fixed charges close to three times over
from its earnings before interest and taxes. That’s a healthy number and likely
means Company A wouldn’t have too much trouble getting a
business loan or finding investors.
Lower FCCR
Company B
has earnings before interest and taxes of $200,000. It pays $5,000 per month
for a building lease, $70,000 annually for equipment, $20,000 per year in
principal payments towards secured business loans and
$50,000 annually in interest.
Based on
the numbers below, here’s how Company A would calculate its FCCR.
·
EBIT: $200,000
·
Fixed charges before taxes:
·
Equipment expenses: $70,000
·
Annual lease: (monthly $5,000 x 12 months) = $60,000
·
Annual principal on a loan: $20,000
·
Annual interest payments: $50,000
Company B’s
FCC ratio is 1.75. That means Company B’s earnings before interest and taxes
are 1.75 times higher than its fixed expenses. While its FCCR isn’t as high as
Company A’s, it’s still above the typical 1.2 required by many lenders. So the
company may be able to get a business loan, but it might not have as many
options — or get a competitive interest rate offer
— as Company A.
Fixed
charge coverage ratio vs. times interest earned
The times
interest earned (TIE) ratio is also a measurement of a company’s ability to
meet its obligations. However, it focuses solely on debt
obligations, whereas the FCCR takes into account all fixed charges.
You
calculate the TIE ratio by dividing a company’s earnings before interest and
taxes by its periodic interest expense.
TIE
formula: TIE ratio = EBIT / interest expense
A company
with a TIE of 2 could pay its periodic interest payments twice over if it
devoted all of its earnings before interest and taxes to debt repayment.
