Fixed charge coverage ratio

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What is the Fixed Charge Coverage Ratio?

The fixed charge coverage ratio is used to examine the extent to which fixed costs consume the cash flow of a business. In effect, it shows how many times a business can pay for its fixed costs with its earnings before interest and taxes. The ratio is most commonly applied when a company has incurred a large amount of debt and must make ongoing interest payments. If the resulting ratio is low, it is a strong indicator that any subsequent drop in the profits of a business may bring about its failure. Conversely, a high ratio indicates that a business can safely use more debt to fund its growth. The ratio is typically used by lenders evaluating an existing or prospective borrower.

How to Calculate the Fixed Charge Coverage Ratio

To calculate the fixed charge coverage ratio, combine earnings before interest and taxes with any lease expense, and then divide by the combined total of interest expense and lease expense. This ratio is intended to show estimated future results, so it is acceptable to drop from the calculation any expenses that are about to expire. The formula is as follows:

((Earnings before interest and taxes) + Lease expense) ÷ (Interest expense + Lease expense)

Example of the Fixed Charge Coverage Ratio

Luminescence Corporation recorded earnings before interest and taxes of $800,000 in the preceding year. The company also recorded $200,000 of lease expense and $50,000 of interest expense. Based on this information, its fixed charge coverage is:

($800,000 EBIT + $200,000 Lease expense) ÷ ($50,000 Interest expense + $200,000 Lease expense)

= 4:1 Fixed charge coverage ratio

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Disadvantages of the Fixed Charge Coverage Ratio

There are several problems with the fixed charge coverage ratio, which are as follows:

  • Historical basis. The information used to compile this ratio is based on historical information, which can be a poor indicator of future performance. To guard against this issue, a lender should also demand to see a borrower’s budget for the upcoming year, to see if any upcoming cash flow issues indicate the presence of impending problems. It would also be useful for a lender to use several other liquidity measures in concert with the fixed charge coverage ratio, to gain a better overall understanding of the borrower’s repayment capabilities.

  • Capital base changes. This ratio does not take into consideration the impact of ongoing additions to the capital base of a business. This is quite common in rapidly-growing startup businesses with venture funding. In these cases, the business will likely burn through its cash quite quickly as it seeks to grow as rapidly as possible, at which point the firm’s backers inject more capital. Talking to the backers about their funding intentions is a good way to get around this issue.

  • Impact of new business lines. The ratio commonly provides a poor outcome for startup businesses, which have incurred large amounts of debt while funding the design and construction of new products. Thus, just when such a business is ready to roll out a profitable line of new products, the fixed charge coverage ratio shows it to be in a precarious position. This concern can be overcome by modeling the expected cash flows from new business lines.