When unfunded capital expenditures and distributions are higher, the resulting fixed charge coverage ratio will be lower. Those figures are subtracted from earnings before interest and taxes, making the earnings before interest and taxes (EBIT) value smaller.
Lease payments and interest payments are included in the fixed charge coverage ratio. Both payments must be met annually. For companies that have extensive expenses for leasing equipment, the fixed charge coverage ratio is an extremely important financial metric. To calculate the ratio, interest expense, taxes and EBIT are all taken from a company’s income statement, and the lease payments are taken from the company’s balance sheet. The fixed charge coverage ratio indicates the number of times a company is capable of covering its yearly fixed charges. When the ratio's value is high, it is a sign that the company's debt situation is in a healthier state. The only true way to determine if the ratio's value is good or bad requires the use of historical information from the company or the use of comparable industry-wide data.
Fixed Charge Coverage Ratio
The fixed charge coverage ratio is a solvency ratio that represents the sufficiency of EBIT to cover all interest and lease payments. When a company incurs a significant amount of debt and must make regular and continuous interest payments, its cash flow can be largely consumed by such costs. The fixed charge coverage ratio is highly adaptable for use with any type of fixed cost; it's easy to factor in costs such as insurance and lease payments, as well as preferred dividend payments.
The fixed charge coverage ratio is similar to the interest coverage ratio. The significant difference between the two is that the fixed charge coverage ratio accounts for the yearly obligations of lease payments in addition to interest payments. This ratio is sometimes viewed as an expanded version of the times interest coverage ratio or the times interest earned ratio. If the resulting value of this ratio is low, less than 1, it is a strong indication that any significant decrease in profits could bring about financial insolvency for a company. A high ratio is indicative of a greater level of financial soundness for a company.
The fixed charge coverage ratio is often used as an alternative solvency ratio to the debt service coverage ratio (DSCR). In terms of corporate finance, the debt service coverage ratio determines the amount of cash flow a business has readily accessible to meet all yearly interest and principal payments on its debt, including payments on sinking funds. If a company's DSCR is less than 1, the company has a negative amount of cash flow. A DSCR of 0.92, for example, means that the company only has enough net operating income to cover 92% of its yearly debt payments.