What is the Fixed-Charge Coverage Ratio
The fixed-charge coverage ratio measures a firm's ability to satisfy fixed charges, such as interest expense and lease expense. Because leases are a fixed charge, the calculation for determining a company's ability to cover fixed charges includes earnings before interest and taxes (EBIT), interest expense, lease expense and other fixed charges. The fixed-charge coverage ratio is calculated as:
(EBIT + lease payments) / (lease payments + interest)
Fixed Charge Coverage Ratio
BREAKING DOWN Fixed-Charge Coverage Ratio
The fixed-charge ratio is commonly used by lenders looking to analyze the amount of cash flow a company has available for debt repayment. A low ratio means a drop in earnings could be dire for the company, a situation lenders try to avoid. As a result, many lenders use coverage ratios, including the times-interest-earned ratio (TIE) and the fixed-charge coverage ratio, to determine a company's ability to take on additional debt. A company that can cover its fixed charges at a faster rate than its peers is not only more efficient, but more profitable. This is a company that wants to borrow for growth rather than hardship.
Fixed-Charge Coverage Ratio Usage
The goal of the fixed-charge coverage ratio is to see how well earnings can cover fixed charges. This ratio is a lot like the TIE ratio, but it is a more conservative measure, taking additional fixed charges, including lease expenses, into consideration.
The fixed-charge coverage ratio is slightly different from the TIE, though the same interpretation can be applied. The fixed-charge coverage ratio adds lease payments to EBIT, and then divides by the total interest and lease expenses. For example, say Company A records EBIT of $300,000, lease payments of $200,000 and $50,000 in interest expense. The calculation is $300,000 plus $200,000 divided by $50,000 plus $200,000, which is $500,000 divided by $250,000, or a fixed-charge coverage ratio of 2x. The company's earnings are two times greater than its fixed costs, which is low. Like the TIE, the higher the ratio, the better.
Understanding Fixed Costs versus Fixed Charges
There are two main parts to any income statement: the sales and the costs of sales. Some costs are variable costs and dependent on the volume of sales over a particular time period. As sales increase, so do the variable costs. Other costs are fixed and must be paid regardless of business activity. These fixed costs can include line items such as lease payments, insurance payments and preferred dividend payments. For the purposes of the fixed-charge coverage ratio, it's not about fixed costs, but fixed charges. Fixed charges include the expenses related to debt (interest expense) or debt-like instruments (leases).