What Does
Fixed Charge Coverage Ratio Mean?
Fixed charge coverage ratio (FCCR) measures whether an organization has the ability to pay its fixed expenses such as tax, interest and lease payments. This is a solvency ratio that is calculated by dividing the value of earnings before interest and taxes (EBIT) and lease payments by the total amount of lease and interest obligations of the organization. It is represented as:
FCCR = (EBIT + Lease Payments Excluding Interest) / (Lease Payments + Interest Payments)
This ratio must be calculated separately for each fixed charge in order to determine the company’s ability to pay these financial obligations. This ratio is best used with similar solvency ratios, like debt ratio, to get a better idea of the financial position of the company.
Divestopedia Explains Fixed Charge Coverage Ratio
The fixed charge coverage ratio helps to determine how much of fixed costs constitute the total cash flow of a business. It is best used when a company has incurred large amounts of debt and is paying high amounts by way of interest. In such a case, the solvency of the company and its ability to service its debt becomes a key factor for creditors, investors and other stakeholders of the organization.
This ratio is typically used by lenders to evaluate the position of the company before money is lent. In general, the higher the ratio, the better the financial ability of the organization to meet its financial obligations. If the resulting ratio is low, then it means that the lenders have a higher level of risk. Accordingly, they can either choose to increase the interest or reduce the loan amount.
For example, ABC company has borrowed a sum of $800,000 of which it pays an interest of $50,000. If their EBIT is $1,200,000, then:
FCCR = ($1,200,000 + $800,000) / ($800,000 + $50,000) = 2.35
Since the ratio is 2.35:1, this makes the company reasonably solvent. However, this ratio is not as high when compared to the loan it has to service; therefore, creditors may try to increase the interest rate to make up for the risk.