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 loans (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.
- A fixed charge is a recurring and predictable expense incurred by a firm.
- Unlike a variable charge, the fixed charge remains the same regardless of the amount of business conducted.
- Fixed charges are most often associated with lease or loan payments, but may also cover regular bills such as utilities or insurance payments.
- The fixed charge coverage ratio is used to measure the solvency of a company and is used by lenders to assess the firm's ability to borrow and service debt.
Understanding Fixed Charges
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.
All companies have fixed charges in one form or another. From day one a company carries fixed charges. The two major categories of fixed charges are loan payments and lease payments as far as a lender to the company is concerned.
The Fixed Charge Coverage Ratio
A 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 of 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.
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.
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 first quarter of 2021, the REIT had a fixed charge coverage ratio of 3.1x.