What is the Fixed-Charge Coverage Ratio (FCCR)?
The Fixed Charge Coverage Ratio (FCCR) is a debt financial ratio that measures a company’s ability to pay off fixed-charges or expenses obligations such as interest expenses and lease expenses.
The fixed charge coverage ratio is basically an extended version of the Times’ interest earned ratio or the times’ interest coverage ratio.
FCCR is the ratio that indicates a firm’s ability to satisfy fixed financing expenses such as interests, insurance payments, preferred dividend payments, salaries, and leases before interest and taxes are accounted for.
As with other commonly used debt ratios, a higher ratio value – preferably 2 or above – indicates a more financially healthy, and less risky, company or situation. A lower ratio value – less than 1 – indicates that the company is struggling to meet its regularly scheduled payments.
In universal case, the standard fixed charge coverage ratio can be 1.25:1 or greater. At the time of renewal and enhancement of a limit or debt prospective lenders look at a company’s fixed charge coverage ratio.
This ratio is evaluated by adding Earnings before Interest and Taxes or EBIT and Fixed-charge which is divided by fixed charge before tax and interest.
Advantage of Fixed-Charge Coverage Ratio Formula
- It measures a company’s ability to pay off fixed-charges or expenses obligation.
- The FCCR shows how well a company’s earnings cover its fixed charges.
- Lenders often use the fixed-charge coverage ratio to assess a company’s creditworthiness.
- A high ratio result shows that a company can adequately cover fixed charges based on its current earnings.
Disadvantage of Fixed-Charge Coverage Ratio Formula
- The FCCR doesn’t judge quick changes in the amount of capital for the new and growing firms.
- It also doesn’t judge the effects of funds.
- It creates an illusion whether taken out of income to pay an owner’s draw or pay dividends to investors.
- Singly, this ratio misleads the conclusion unless other metrics are also considered.
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Formula Fixed-Charge Coverage Ratio Formula
The formula for calculating this ratio is as follows:
- Full form of EBIT for earnings before interest and taxes.
- Fixed charges are regular, business expenses that are paid regardless of business activity. Examples of fixed charges include debt installment payments, business equipment lease payments, and insurance premiums.
The terms used in the formula, we can explain in details like as:
A company’s EBIT is also known as the operating income, operating earnings, or operating property.
It is calculated by taking the total annual revenue and subtracting the cost of goods sold (COGS) and operating expenses. The operating expenses include things like wages and benefits for employees, plus the cost of research and development.
EBIT tells you your business’s net income before income taxes and interest are deducted.
Fixed charges are calculated annually and can include any number of regular charges like lease payments, loan payments, insurance premiums, and employee wages.
However, if you deduct rent as part of the operating expenses for your EBIT figure, you will not need to include it as part of the fixed charge.
Most of what a business will account for as fixed charges can be deducted as business expenses.
The last variable in this ratio’s formula is Interest. Your interest expenses can be calculated by multiplying the total dollar amount of outstanding debt by the interest rate on the debt. It should also appear in your profit and loss statement.
Example of Fixed-Charge Coverage Ratio
XYZ operates the grocery in the city of New Delhi. The enterprise’s monthly expenses include lease payments of $5,000, insurance costs for the goods at $1,000, and insurance costs for the company’s work vehicle at $500. XYZ Enterprise generated EBIT of $500,000 and has an annual interest expense of $50,000. The fixed-charge coverage ratio for XYZ Enterprise would be calculated as follows:
- Converge monthly fixed-charges to annual amounts:
- Monthly lease payments of $5,000 x 12 = $60,000 annually
- Monthly insurance costs of the goods: $1,000 x 12 = $12,000 annually
- Monthly insurance costs of the car: $500 x 12 = $6,000 annually
Therefore, annual fixed-charges equate to $60,000 + $12,000 + $6,000 = $78,000
- Apply the FCCR formula:
Interpretation and Analysis of the Fixed-Charge Coverage Ratio
The FCCR is used to find out a company’s ability to pay its fixed payments. In the example above, XYZ’s Enterprises would be able to meet its fixed payments 4.51 times.
The ratio measures how many times a firm can pay its fixed costs with its income before interest and taxes.
In simple words, how many times larger the income of the firm is compared with its fixed costs.
The fixed-charge coverage ratio is known as a solvency ratio for the reason that it shows the ability of a company to repay its ongoing financial obligations when they are due.
If a company is unable to meet its recurring monthly or annual financial obligations, then it is in serious financial distress. Unless the situation is remedied quickly, efficiently, and safely, it is unlikely that the company will be able to remain financially afloat for very long.
Here is a way to assess the FCCR number:
- An FCCR equal to 2 (=2) means that the company can pay for its fixed charges two times over.
- An FCCR equal to 1 (=1) means that the company is able to pay for its annual fixed charges and saves nothing from the business.
- An FCCR of less than 1 (<1) means that the company lacks enough money to cover its fixed charges.
Therefore, generally utterance, the higher the fixed-charge coverage ratio value is the better, as this indicates a company operating on the solid financial ground, with adequate revenues and cash flows to meet its regular payment obligations.
The FCCR is frequently used by lenders or market analysts to consider the sufficiency of a firm’s cash flows to handle the firm’s recurring debt obligations and regular operating expenses.