A:

One main advantage of using the fixed-charge coverage ratio is it provides a good, fundamental assessment for lenders or investors to evaluate a company's basic ability to handle its current financing level. Another advantage is it provides a more complete assessment than an alternative financial leverage ratio, the interest coverage ratio, since it includes lease payments in addition to interest payments on financing. The main disadvantage of using the fixed-charge coverage ratio is it fails to take into account significant changes in working capital that may occur with a rapidly growing company.

The fixed-charge coverage ratio is a basic financial leverage or solvency ratio commonly used by lenders to evaluate a company's ability to manage financing. It indicates the company's available coverage to meet fixed financing expenses of interest payments and leasing charges. This ratio is, therefore, especially useful for evaluating firms with significant leasing costs. The fixed-charge coverage ratio measures the sufficiency of earnings before interest, taxes and lease payments to cover fixed payments of interest and leases. The ratio is calculated by dividing the total of earnings before interest and taxes, or EBIT, and lease payments by the total amount of interest and lease payments.

The fixed-charge coverage ratio is similar to the interest coverage ratio but offers the additional benefit of factoring in the ongoing charges for lease payments along with the basic financing costs of regular interest payments. Obviously, this extra calculation is more significant, depending on the amount of lease payments a company is obligated to pay, and of no significance at all for a company with no leasing expenses whatsoever.

A higher fixed-charge coverage ratio indicates greater financial solvency, since the ratio's calculation reveals the number of times per year the firm is capable of making its required annual fixed financing payments. The ratio offers the advantage of being a simple calculation for lenders or investors that is easily done with information readily available from a company's income statement and balance sheet. What is considered an acceptable ratio varies from industry to industry and the specific business, but a ratio of 1.25:1 is a minimum standard commonly used by lenders. A ratio of 1.5:1 or higher is generally considered good to excellent. As with all equity evaluation ratios, the ratio is best employed by looking at industry averages for similar companies or by looking at the company's historical trend in terms of financial coverage.

One significant disadvantage, or shortcoming, of the fixed-charge coverage ratio is that, while it is intended to measure the ability of a company's cash flow to meet financing obligations, it does not factor in the important cash flow variable of a significant change in working capital. The level of a company's working capital may shift dramatically when the company is rapidly growing and experiencing substantial changes in accounts receivables or inventory levels. Therefore, examination of a company's fixed-charge coverage ratio can be enhanced by also considering other financial ratios, such as the company's debt ratio or cash conversion cycle.

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