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.

  1. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Discover how the fixed charge coverage ratio is useful to investors and analysts, and when it suggests that a company should ... Read Answer >>
  2. What is the difference between interest coverage ratio and TIE?

    Read about the times interest earned, also known as the interest coverage ratio. Find out why this is an important ratio ... Read Answer >>
  3. What are the most common leverage ratios for evaluating a company?

    Learn more about some of the most common leverage ratios used by traders to determine whether a company is using debt in ... Read Answer >>
  4. What's the difference between the coverage ratio and the levered free cash flow to ...

    Learn the differences between the equity evaluation metric, the levered free cash flow to enterprise value ratio and various ... Read Answer >>
  5. What is the difference between interest coverage ratio and DSCR?

    Understand the basics of the interest coverage ratio and the debt-service coverage ratio, including calculations and how ... Read Answer >>
Related Articles
  1. Investing

    An Introduction To Coverage Ratios

    Interest coverage ratios help determine a company's ability to pay down its debt.
  2. Investing

    Analyze Investments Quickly With Ratios

    Make informed decisions about your investments with these easy equations.
  3. Investing

    Analyzing Wal-Mart's Debt Ratios in 2016 (WMT)

    Analyze Wal-Mart's debt-to-equity ratio, interest coverage ratio and cash flow-to-debt ratio to evaluate the company's financial health and debt management.
  4. Investing

    Analyzing AT&T's Debt Ratios in 2016 (T)

    Learn about AT&T Inc. and its key debt ratios, such as the debt-to-equity ratio, interest coverage ratio and cash flow-to-debt ratio.
  5. Investing

    Do Your Investments Have Short-Term Health?

    If a company is strong enough to survive tough times, it is more likely to provide long-term value.
  6. Investing

    Ratio Analysis

    Ratio analysis is the use of quantitative analysis of financial information in a company’s financial statements. The analysis is done by comparing line items in a company’s financial ...
  7. Investing

    Analyzing Investments With Solvency Ratios

    Solvency ratios are extremely useful in helping analyze a firm’s ability to meet its long-term obligations; but like most financial ratios, they must be used in the context of an overall company ...
  8. Financial Advisor

    The Debt To Equity Ratio

    The debt to equity ratio identifies companies that are highly leveraged and therefore a higher risk for investors. Find out how this ratio is calculated and how you can use it to evaluate a stock.
  1. Fixed-Charge Coverage Ratio

    A ratio that indicates a firm's ability to satisfy fixed financing ...
  2. Coverage Ratio

    A measure of a company's ability to meet its financial obligations. ...
  3. Ratio Analysis

    A ratio analysis is a quantitative analysis of information contained ...
  4. Lease Payments

    A line item under long-term debt on a balance sheet that indicates ...
  5. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ...
  6. EBITDA-To-Interest Coverage Ratio

    A ratio that is used to assess a company's financial durability ...
Hot Definitions
  1. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
  2. Inverse Transaction

    A transaction that can cancel out a forward contract that has the same value date.
  3. Redemption

    The return of an investor's principal in a fixed income security, such as a preferred stock or bond; or the sale of units ...
  4. Solvency

    The ability of a company to meet its long-term financial obligations. Solvency is essential to staying in business, but a ...
  5. Dilution

    A reduction in the ownership percentage of a share of stock caused by the issuance of new stock. Dilution can also occur ...
  6. Agency Problem

    A conflict of interest inherent in any relationship where one party is expected to act in another's best interests. The problem ...
Trading Center