What is the 'Fixed-Charge Coverage Ratio'
The fixed-charge coverage ratio (FCCR) measures a firm's ability to satisfy fixed charges, such as interest expense and lease expense. Since leases are a fixed charge, the calculation for determining a company's ability to cover fixed charges includes earnings before interest and taxes (EBIT), interest expense, lease expense and other fixed charges. It is calculated as:
BREAKING DOWN 'Fixed-Charge Coverage Ratio'
Also referred to as the solvency ratio, the fixed-charge ratio is commonly used by lenders attempting to analyze the amount of cash flow a company has available for debt repayment. A low ratio means a drop in earnings could be dire for the company, a situation lenders try to avoid. As a result, many lenders use coverage ratios, including the times-interest-earned ratio (TIE) and the fixed-charge ratio, to determine a company's ability to take on additional debt. A company that can cover its fixed charges at a faster rate than its peers is not only more efficient, but more profitable. This is a company that wants to borrow for growth rather than hardship, which is the kind of company in which most investors are looking to invest.
Fixed vs. Variable Charges
There are two main parts to any profit and loss statement: sales and the cost of sales. Some costs are variable and dependent on the volume of sales over a particular time period. Other costs are fixed and must be paid regardless of business activity. These are called fixed costs and include line items such as lease payments, insurance payments and preferred dividend payments.
Interpretation and Usage
The goal of the fixed-charge coverage ratio is to see how well earnings can cover fixed charges. This ratio is a lot like the TIE ratio, a popular ratio used to measure a company's ability to cover interest with EBIT. TIE is calculated by dividing EBIT by the total interest paid on debt. A TIE of five means the company's EBIT is able to cover the company's interest payment five times. The fixed-charge coverage ratio is a more conservative measure as it takes additional fixed charges, including lease expense, into consideration.
The fixed-charge coverage ratio is slightly different from the TIE, though the same interpretation can be applied. The fixed-charge coverage ratio is calculated by adding EBIT to fixed charges before taxes, and then dividing by the total of interest expense and fixed charges before taxes. For example, say company A records EBIT of $300,000, fixed charges before taxes of $200,000 and $50,000 in interest expense. The calculation is $300,000 plus $200,000 divided by $50,000 plus $200,000, which is $500,000 divided by $250,000, or 2:1. The company's earnings are two times greater than its fixed costs, which is low. Like the TIE, the higher the ratio the better.