Fixed Charge Coverage Ratio
The Fixed Charge Coverage Ratio (FCCR) is a solvency ratio that measures a company’s ability to cover its fixed charges, such as interest and lease expenses, with its income before interest and taxes. It is an indicator of the financial health of a company and its ability to meet its fixed obligations.
The formula to calculate the Fixed Charge Coverage Ratio is:
\(\text{Fixed Charge Coverage Ratio} = \frac{\text{(Earnings Before Interest and Taxes + Fixed Charges Before Tax)}}{\text{(Fixed Charges Before Tax + Interest)}} \)
Where:
- Earnings Before Interest and Taxes (EBIT) is a measure of a company’s profitability that excludes interest and income tax expenses.
- Fixed Charges Before Tax typically include operating lease payments.
A higher Fixed Charge Coverage Ratio indicates that the company is better able to cover its fixed charges from its operational earnings. It gives creditors and investors an idea of the company’s financial stability and its ability to pay its fixed costs, even in times of financial difficulty.
Like all financial ratios, the Fixed Charge Coverage Ratio should be used in conjunction with other financial analysis tools and ratios to assess a company’s financial health.
Example of the Fixed Charge Coverage Ratio
Let’s consider an example of a manufacturing company with the following financial information for the past year:
- Earnings Before Interest and Taxes (EBIT): $1,000,000
- Interest Expenses: $200,000
- Operating Lease Expenses: $100,000
We can calculate the Fixed Charge Coverage Ratio (FCCR) as follows:
First, calculate the total fixed charges, which include both interest expenses and lease expenses: Fixed Charges Before Tax = Interest Expenses + Operating Lease Expenses = $200,000 + $100,000 = $300,000
Next, plug the numbers into the FCCR formula:
\(\text{Fixed Charge Coverage Ratio} = \frac{\text{(EBIT + Fixed Charges Before Tax)}}{\text{(Fixed Charges Before Tax + Interest)}} \)
\(\text{Fixed Charge Coverage Ratio} = \frac{\text{(\$1,000,000 + \$300,000)}}{\text{(\$300,000 + \$200,000)}} = \frac{\text{\$1.3 million}}{\text{\$500,000}} = 2.6\)
A FCCR of 2.6 means that the company’s earnings are 2.6 times its fixed charges. In other words, for every dollar the company has in fixed charges, it has $2.6 in earnings to cover those charges. This suggests that the company is in a relatively good position to meet its fixed obligations.
As always, this ratio should be compared with industry benchmarks or competitors to understand its significance better. Also, the FCCR should be viewed in the context of other financial ratios and metrics to get a complete picture of a company’s financial health.
