Fixed-Charge Coverage Ratio

Fixed-Charge Coverage Ratio
See also
Normal cost Debt service coverage Debt to total assets ratio Accrual rate Combined Ratio Solvency ratios Closed-End Lease Ebitda ratio Yield maintenance

Fixed-Charge Coverage Ratio - is defined as financial ratio, also known as FCCR. FCCR determines company's long-term ability to pay all of its fixed charges from the income generated before any fixed financing charges are considered (earnings before interest and taxes + lease payments) . It is an ability to satisfy all of fixed financial costs, more precisely - fixed charges .

FCCR is more advanced version of another ratio - Times Interest Earned Ratio (TIE) . Fixed-Charge Coverage Ratio represents the ratio of fixed charges to some degree of cash flow. Fixed charges can be defined as covering dividends and interests expense . A ratio is calculated by dividing earnings which are available to cover all fixed charges by all fixed charges. Fixed charges include: long-term lease obligations (lease payments), insurance payments, sinking funds payments and preferred dividend payments . In particular by using ratios like Fixed-Charge Coverage Ratio, the company can avoid any difficulties of assessing leverage during worse period and for example fluctuating property values .

Fixed-Charge Coverage Ratio Formula

The formula is :

$FCCR={\frac {EBIT+FCBT}{FCBT+I}}$

Where:

• FCCR - Fixed-Charge Coverage Ratio
• EBIT - Earnings Before Interest and Taxes
• FCBT - Fixed Charge Before Tax
• I - Interest

Example of calculation Fixed-Charge Coverage Ratio

Company X has $1,000,000 of income before interest and taxes and $100,000 of interest expense. The enterprise also bears the costs of lease payments - $200,000.

The solution: $FCCR={\frac {\$1,000,000+\$200,000}{\$200,000+\$100,000}}=4$

The ratio presents that company's earnings before interest and taxes can cover fixed charges 4 times .

Interpretation of Fixed-Charge Coverage Ratio

Fixed-Charge Coverage Ratio enable to carry out the coverage test. The higher the ratio, the better for investors and creditors. The lower the ratio, the more risky and unstable company is .

Advantages of Fixed-Charge Coverage Ratio

Fixed-Charge Coverage Ratio is a useful tool for assessing a company’s ability to pay its fixed obligations. It provides a simple calculation that allows lenders and investors to quickly assess the financial health of a company. The following are some of the advantages of the fixed-charge coverage ratio:

• It provides a quick and easy way to measure a company’s ability to pay its fixed expenses.
• It gives lenders and investors a useful benchmark to assess a company’s financial health.
• It takes into account both operating income and any lease payments made by the company.
• It provides a measure of the company’s ability to meet its current obligations while still accumulating additional capital.
• It is an easily understandable measure of a company’s financial health that can be used by all stakeholders.

Limitations of Fixed-Charge Coverage Ratio

The Fixed-Charge Coverage Ratio (FCCR) is a financial ratio used to measure a company's ability to pay its fixed charges from its income. Although it is a useful tool in analyzing a company's financial health, there are several key limitations to consider when using this ratio. These limitations include:

• The ratio does not take into account the company's cash flows which can be an important factor in assessing a company's financial stability.
• The ratio does not consider the company's total debt obligations, only the fixed financing charges, which may not give an accurate picture of a company's financial health.
• The ratio is subject to manipulation and does not account for non-cash items such as depreciation and amortization expenses.
• The ratio does not consider other important factors such as the company's working capital and the quality of its assets.
• The ratio is backward-looking, so it does not provide any insight into a company's future financial health.

Other approaches related to Fixed-Charge Coverage Ratio

• Operating Income Coverage Ratio (OICR): This ratio measures the ability of a company to cover its fixed charges with operating income. It is calculated by dividing operating income by total fixed charges.
• Cash Flow Coverage Ratio (CFCR): This ratio measures the ability of a company to cover its fixed charges with cash flow. It is calculated by dividing cash flow from operations by total fixed charges.
• Debt Service Coverage Ratio (DSCR): This ratio measures the ability of a company to cover its fixed charges with debt service payments. It is calculated by dividing total debt service payments by total fixed charges.

In summary, Fixed-Charge Coverage Ratio is a financial ratio used to measure the ability of a company to cover its fixed charges with income generated before any fixed financing charges are considered. Other approaches related to Fixed-Charge Coverage Ratio include Operating Income Coverage Ratio, Cash Flow Coverage Ratio, and Debt Service Coverage Ratio.

References

• Beenhakker H.L. (1996), Investment Decision Making in the Private and Public Sectors, Quorum Books
• Besley S., Brigham E.F. (2009), Principles of Finance, Cengage Learning
• Block R.L. (2012), Investing in REITs: Real Estate Investment Trusts, John Wiley & Sons
• Fridson M.S. (2018), Foundations of High-Yield Analysis, CFA Institute Research Foundation
• Gadge A., Deora B., Kasture R. (2013), Certified Credit Research Analyst (CCRA) Level 1, Taxmann
• Peterson P.P., Fabozzi F.J. (1999), Analysis of Financial Statements, John Wiley & Sons
• Qatar Financial Centre (2015), QFINANCE: The Ultimate Resource, Bloomsbury

Author: Oksana Szłapowska