Fixed Charge Coverage Ratio:

 

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.