The fixed charge coverage ratio measures a business capacity to cover its interest, leases, insurance premiums and other fixed expenses that consist in a recurring financial obligation for the company. The ratio is stated in times, which means that the result of the calculation can be read as X times covered. A company with a high coverage will be seen as a financial stable venture and therefore, lenders and creditors will be inclined to extend more credit to the business.
What is the Fixed Charge Coverage Ratio?
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This ratio is widely employed in finance to determine a company’s capacity to meet its financial obligations. It becomes particularly important to potential bond investors, who will look deeply into this metric to make sure the bonds are backed by an entity that has the capacity to fulfill the coupon payments associated to the bond issue.
On the other hand, lenders will also look into this metric to extend business loans, and they often have a minimum coverage requirement for different industries. If the coverage is below that mark, then the loan will probably be denied or a collateral will be demanded in order to approve it.
Finally, companies that are highly levered have to make sure this metric remains stable over time, to make sure the value of its debt stays within a certain range to make sure that any new funding they may need to gather enjoys a decent interest rate. The lower the coverage ratio, the riskier the business, in the eyes of potential lenders and investors.
Fixed Charge Coverage Ratio Formula
The formula to calculate the fixed charge coverage ratio is:
Fixed Charge Coverage Ratio (FCCR) = EBIT + Fixed Charges before tax / Fixed Charges before tax + i
Fixed Charge Coverage Ratio Equation Components
EBIT: Earnings before interest and taxes.
Fixed charges before tax: Any monthly or annual fixed payments made for insurance, leases, preferred dividends and installment payments on any other service.
I: Interest expenses.
The end result of the formula is understood as the number of times the fixed payments are covered by the earnings produced by the business.
Fixed Charge Coverage Example
All Coffee is an e-commerce business that commercializes everything related to making coffee for people who aficionado, amateur and professional baristas, and for coffee lovers as a whole.
The company has seen a significant growth in its revenues since the website was first launched. The first year they sold $350,000 4 months after the launch. Yet, the next two years the website went viral and it started selling more than $6,700,000 per year. The company is now a renowned e-commerce niche business and its looking for additional financing to sustain its growth.
Last year EBIT was $1,500,000 and their current fixed charges are these:
Employee Insurance Annual Premium: $34,000
Software Licenses: $89,000
Car leases: $125,300
Total Fixed Charges: $248,300
Interest expenses on current debt: $67,400
Principal to be paid on current debt per year: $250,000
In order to estimate the current fixed charge coverage ratio, the formula will go as follows:
FCCR = ($1,500,000 + $248,300 + $250,000) / ($248,300 + $67,400 + $250,000)
FCCR = $1,998,300 / $565,700 = 3.5
It appears the company has a coverage ratio of 3.5 times, which means the current earnings cover fixed charges 3.5 times.
Fixed Charge Coverage Ratio Analysis
Analyzing a business payment capacity is crucial for lenders and creditors who are looking to extend credit lines. Simply put, the higher the coverage ratio the better, as it means the company has the capacity to undertake additional debt, while fulfilling the current financial commitments.
A low coverage ratio may indicate that the business is struggling with producing enough earnings to cover for its fixed charges and interest expenses, this is a particularly risky situation for a lender or creditor to step in, as any additional money borrowed by the business will further reduce the coverage ratio, risking a potential default on any of these payments.
A business may suffer from a low coverage ratio for several reasons. First and foremost, the company may have been experienced a sales decrease, which directly affects its earning capacity. Additionally, gross margins may be low and operating expenses are eating almost the entire earning capacity of the business. Finally, the business’ administration may not be adequate and certain expenses are out of control, affecting the company’s earning capacity.
In any case, the coverage ratio has to be increased to a point where lenders and creditors feel its safe to lend their money. For most industries, a coverage ratio above 3 or 4 can be considered healthy enough.
In the example above, All Coffee shows a 3.5 coverage ratio on its fixed charges. Yet, a thorough analyst would dig deeper into the sustainability of the current sales level, as e-commerce businesses are very susceptible to competition and marketing setbacks. If the company suffers from a market downturn, this coverage ratio will suffer significantly. The best way to understand how sensitive the business is would be to model different scenarios to see where the coverage ratio would end up at if sales decrease by X percentage next year.
Fixed Charge Coverage Ratio Uses, Cautions, & Pitfalls
Given the fact that all businesses and industries are different from each other to some extent, establishing a one-size-fits-all coverage ratio is not the most accurate way to approach the metric. Instead, most lenders and investors compare companies of similar size within the same industry to analyze which value can be considered as a healthy one.
It is important to also keep in mind which items are included as fixed charges for the estimation of the coverage ratio. These fixed charges remain stable regardless of the company’s sales and depending on the analyst’s scope, it could include items like rent, leases, insurance payments, pension contributions, service contract installments and any other items that will remain untouched even though sales may decrease. The higher the amount of fixed charges in proportion to the business’ EBIT, the more exposed the business will be to potential defaults coming it a market downturn occurs.
Finally, items such as marketing expenses and payroll should not be included in the calculation of total fixed charges, as those can be easily modified in the short terms if sales decrease.