Can your business meet its fixed charges month after month, year after year?
A fixed charge is a recurring fixed expense, like insurance, salaries, auto loans and mortgage payments. If you can't meet these expenses, you're not likely to remain in business for long. A way of measuring your company's ability to meet these fixed charges is the fixed charge coverage ratio (FCCR), an expanded but more conservative version of the times interest earned ratio.
The fixed charge coverage ratio, or solvency ratio, is all about your company's ability to pay all of its fixed charge obligations or expenses with income before interest and income taxes. The fixed charge coverage ratio is very adaptable for use with almost any fixed cost since fixed costs like lease payments, insurance payments, and preferred dividend payments can be built into the calculation.
The fixed charge coverage ratio is especially important for firms that extensively lease equipment, for example.
Lenders look at the fixed charge coverage ratio to understand the amount of cash flow a company has for debt repayment. If the ratio is low, lenders see it as bad news for a company looking to take on additional debt because any drop in earning could be dire. If the ratio is high, it indicates the company is more efficient and more profitable and may be looking to borrow for growth rather than to compensate for a bad period.
FCCR = Earnings Before Interest and Taxes (EBIT) + Lease Payments / Interest Expense + Lease Payments
EBIT, Taxes, and Interest Expense are taken from the company's income statement. Lease Payments are taken from the balance sheet and are usually shown as a footnote on the balance sheet. The result of the fixed charge coverage ratio is the number of times the company can cover its fixed charges per year. The higher the number, the better the debt position of the firm, similar to the times interest earned ratio.
Like all ratios, you can only make a determination if the result of this ratio is good or bad if you use either historical data from the company or if you use comparable data from the industry. An analysis will help a business to create a more predictable budget and estimate cash flows more accurately.
Let's say the ABC company shows an EBIT of $150,000. The sum of its fixed charges before taxes, mostly in lease payments, is $100,000. To that, we add interest expenses of $25,000. The fixed charge coverage ratio is then calculated as $150,000 plus $100,000, or $250,000, divided by $25,000 plus $100,000, or $125,000. the resulting ratio is 2:1, which means that the company's income is twice as great as its fixed costs.
Higher fixed cost ratios indicate that a business is healthy and further investment or loans are less risky. Lower ratios indicate weakness and an income insufficient to meet the business' monthly bills. Obviously, the higher the ratio, the better.