The fixed charge coverage ratio (FCCR) measures a company’s ability to pay its fixed charges—such as debt service, leases and insurance—which reveals the extent to which fixed costs consume a company’s cash flow. A high ratio is reassuring, because there is plenty of cash to cover fixed costs. However, a low ratio is troubling, as it indicates a company that might have difficulty generating a profit. FCCR is used by companies and investors to assess overall financial health, and by creditors evaluating a potential borrower’s creditworthiness.
Fixed Charge Coverage Ratio Definition and Terms
FCCR is a measure of a firm’s solvency—meaning, the ability to pay its bills. An insolvent company lacks the cash necessary to operate, generally resulting in bankruptcy. The terms used to calculate FCCR all touch upon the amount of money a company must spend on fixed charges and the earnings available to do so.
Earnings before interest and taxes (EBIT): The operating income of the company before you deduct the costs for interest and taxes. Sales generate gross revenues, from which operating expenses and the cost of goods sold are subtracted to give the operating income. Another way to calculate EBIT is to start with the profit for the period and add back interest and tax expenses. The company’s income statement has the data necessary to calculate EBIT.
Fixed costs: These are independent costs—at least in the short run—of business activity. In other words, a company has to pay the same fixed costs whether it had good or poor sales for the period. Examples of fixed costs include repayment of loan principal, rent, salaries, and other operating expenses. Most fixed costs are reflected in EBIT—they’ve already been subtracted from revenues. However, certain fixed expenses—namely leases—are not included in EBIT and must be added in to accurately calculate FCCR.
Lease expense: Leasing is a method of paying for the use of an assets such as machinery, offices, vehicles and warehouses. Rather than purchase the asset, a company can lease it and pay a fixed monthly rent for its use. An implicit interest charge is figured into the rent. In some leases, the lessee returns the asset at lease end—while in other leases, the lessee can purchase the asset at a bargain price when the lease expires.
Interest expense: Interest is the money a borrower is charged for the use of credit, such as loans and credit card balances. Interest is usually paid periodically on the outstanding balance of borrowings. Some interest expenses are fixed, they stem from certain loans or bonds that aren’t repaid until they mature. For example, a company that issues a bond generally must periodically pay bondholders interest, but doesn’t repay the principal until the bond is redeemed. Other interest charges vary with credit balances—such as those for credit card balances and mortgages—in which some of the principal must be repaid each month. All interest charges are included in the calculation of FCCR.
How to Calculate Fixed Charge Coverage Ratio
FCCR is calculated by comparing the earnings available to pay fixed charges to the money needed to pay for interest and leases:
FCCR = (EBIT + Lease Expense) ÷ (Interest Expense + Lease Expense)
An FCCR ratio of two indicates a company has twice the cash flow necessary to pay for its fixed costs. The higher the FCCR ratio, the better. An FCCR value of 1.25 is often considered the minimum acceptable ratio.
As an example, consider Company X, a brick-and-mortar retail store that has EBIT for the year of $900,000. In the same year, the company recorded a $50,000 interest expense on vehicle loans and a $300,000 lease expense to rent retail space. The company’s FCCR is calculated as follows:
FCCR = ($900,000 EBIT + $300,000 Lease Expense) ÷ ($50,000 Interest Expense + $300,000 Lease Expense)
FCCR = $1,200,000 ÷ $350,000
FCCR = 3.43
How to Interpret the Fixed Charge Coverage Ratio
The FCCR tells you how well a company can cover its fixed costs. If the FCCR is less than one, the company has not earned enough to pay for its fixed costs, and will have to come up with the money from another source—such as debt or equity. If the company cannot pay these costs, it is headed towards insolvency and bankruptcy. An FCCR value of one or higher means that earnings will cover its fixed costs. Generally speaking, a number below 1.25 is worrying, because it doesn’t give the company a good earnings cushion should revenues be disrupted.
Context is important when interpreting FCCR. The ratio should be evaluated in comparison to the company’s historical FCCR and to that of competitors. Where the company is in its business cycle must also be factored in. For instance, a startup or high-growth company might have a low FCCR because it spends a large amount on leases and loans to expand its business.
Creditors use FCCR as a tool to judge the risk that a borrower will default on a loan. Lessors have a similar interest in knowing whether a lessee will be able to make its lease payments. Investors might look at FCCR as part of their due diligence before they invest money into a company.
Internally, company management can use FCCR to monitor the health of the business, and to evaluate the feasibility of projects that increase fixed costs and thus lower FCCR below a critical level. Management can also compare current and historical FCCRs to detect any developing earnings problems. Companies can consider various remedies to a declining or low FCCR, such as reducing selling costs, negotiating lower lease rates, and refinancing high-interest borrowings at a lower rate.