What Is a Fixed Charge?
A fixed charge is any type of expense that recurs on a regular basis, regardless of the volume of business. Fixed charges mainly include loan (principal and interest) and lease payments, but the definition of "fixed charges" may broaden out to include insurance, utilities, and taxes for the purposes of drawing up loan covenants by lenders.
Fixed Charges Explained
Before a business sets up, it lists all the necessary upfront and ongoing expenses. The expenses are then separated into two buckets: fixed and variable. The variable expenses depend on the volume of business. For example, a salesperson's commission is determined by how much of the company's products or services are sold. Fixed expenses, on the other hand, exist regardless of the volume of business.
The two major categories of fixed charges are loan payments and lease payments as far as a lender to the company is concerned. The lender may also capture other fixed expenses such as insurance, utilities, and taxes, but most loan covenants for the fixed charge coverage ratio (FCCR) focus on loan and lease payments. The FCCR is one a few important measures of the repayment capacity of a borrower; obviously, the higher the coverage ratio – which uses earnings before interest and taxes (EBIT) as the numerator and fixed charges as the denominator – the better. A variant of FCCR is earnings before interest, taxes, depreciation and amortization (EBITDA) over fixed charges. A company that has burdensome fixed charges and insufficient volumes of business to cover the fixed expenses, let alone the variable ones, will be in trouble with its creditors, who possess collateral on business assets and in some cases personal assets as well.
Example of a Fixed Charge
Federal Realty Investment Trust, a REIT, lists fixed-rate debt (principal and interest), capital lease obligations (principal and interest), variable rate debt (principal only) and operating leases among its fixed charges. As of the end of the third quarter of 2017, the REIT had a fixed charge coverage ratio of 4.1x, which was higher than most of the FCCRs of its peer group.
Walking by a Fixed Charge
All companies have fixed charges in one form or another. From day one a company carries fixed charges. It shouldn't be a surprise that a retail store with low volumes of customer flow eventually goes out of business. Perhaps it was because there was not enough foot traffic in the area or it did not have competitive offerings for customers. If a "Going Out of Business" sign hits the window, it most likely means it couldn't "make the rent."