Fixed-Charge Coverage Ratio: Ensuring Financial Resilience
The fixed-charge coverage ratio (FCCR) evaluates a company’s aptitude for covering its fixed charges, such as debt repayments, interest expense, and lease obligations. This essential metric illustrates how reliably a company’s earnings can handle its significant fixed costs, an aspect closely scrutinized by banks when granting loans.
Key Takeaways
- The FCCR measures a company’s capability to cover fixed charges like rent, utilities, and debt, using available earnings.
- Lenders use the FCCR to evaluate a company’s creditworthiness and potential financial stability.
- A high FCCR suggests a strong ability to cover fixed charges, enhancing the company’s appeal for borrowing.
Unveiling the Formula for the Fixed-Charge Coverage Ratio
The formula used to determine the Fixed-Charge Coverage Ratio is:
(FCC Ratio = \frac{EBIT + FCBT}{FCBT + interest})
Where:
- EBIT: Earnings Before Interest and Taxes
- FCBT: Fixed Charges Before Tax
- interest: Interest expenses
Calculating the Fixed-Charge Coverage Ratio
The calculation begins with a company’s earnings before interest and taxes (EBIT) from its income statement, adding back interest and lease expenses, which considers other fixed charges. Then, the resultant adjusted EBIT is divided by the aggregate of fixed charges and interest. For instance, a ratio of 1.5 reflects the company can cover its fixed charges and interest by 1.5 times its earnings.
Insights From the Fixed-Charge Coverage Ratio
Lenders focus on the fixed-charge ratio to assess the cash flow adequacy for repaying debts. A low ratio signals potential difficulties in meeting fixed charges, indicating higher repayment risks, a situation lenders tend to avoid. High FCCRs often go hand-in-hand with higher efficiency and profitability, inherently making these companies more attractive for growth financing rather than crisis management.
Practical Example of FCCR Application
Consider Company A, which reports an EBIT of $300,000, lease payments of $200,000, and an interest expense of $50,000.
[FCC Ratio = \frac{300,000 + 200,000}{200,000 + 50,000} = \frac{500,000}{250,000} = 2x]
This indicates the company’s earnings are twice its fixed costs, which is relatively low, hinting at potential future inability to meet fixed payments. Typically, a higher ratio is more favorable.
Recognizing the FCCR’s Limitations
The FCCR doesn’t take into account rapid financial changes in growing companies or the impacts of dividends and owner draws, which can skew the ratio. Hence, lenders complement the FCCR with other benchmarks for a holistic creditworthiness assessment during loan evaluations.
Related Terms: earnings before interest and taxes, times-interest-earned ratio, creditworthiness, income statement
