Fixed charge coverage ratio (FCCR) measures a company’s ability to cover its fixed expenses from its earnings. Lenders may evaluate this as one of several factors in determining whether you qualify for a loan, as well as what interest rate and loan terms you qualify for.
A fixed charge coverage ratio above 1.2 is required by most lenders, while a ratio greater than two will give you the best chance of getting the most favorable rates. The FCCR shows how much more earnings can cover fixed expenses. An FCCR of 2, for example, means that the company’s earnings can cover its fixed expenses two times over.
If you’re looking for a small business loan, a broker like Lendio can help match you with the right financing option. With a network of over 75 lenders, you can also more easily get funding at the best available rates and terms.
Fixed Charge Coverage Ratio Formula
FCCR = | Earnings before interest and taxes + Fixed charges before tax |
Fixed charges before tax and interest |
Earnings Before Interest & Taxes
Earnings before interest and taxes (EBIT) is determined by taking a company’s gross revenue and subtracting interest expenses, income taxes paid, and other operating expenses. Alternatively, it can be calculated by taking net income and adding back interest and taxes. It’s often also referred to as operating income and can be found by referencing your company’s balance sheet.
Fixed Charges Before Tax
Fixed charges before tax refers to the expenses your company is obligated to pay on a recurring basis. This can include things like lease payments, insurance payments, loan payments, and other debt obligations.
Fixed Charges Before Tax & Interest
This figure for the FCCR formula is calculated by taking the fixed charges before tax and simply adding back the interest expenses associated with the debt payments.
Example of How to Calculate Fixed Charge Coverage Ratio
Below is an example of how to calculate FCCR:
Earnings and Expense Figures | |
Annual Earnings Before Interest (EBIT) | $500,000 |
Annual Lease Payments | $100,000 |
Annual Insurance Premiums | $50,000 |
Annual Principal Payments on an Equipment Loan | $200,000 |
Annual Interest Expense Portion From Debt Payments | $150,000 |
FCCR Calculation Steps | |
Fixed Charges | $100,000 lease payments + $50,000 insurance premiums + $200,000 principal payments = $350,000 |
FCCR Final Calculation | ($500,000 EBIT + $350,000) / ($350,000 + $150,000 interest) = 1.7 |
Why FCCR Is Important
FCCR is used by lenders to determine your eligibility for a loan. In general, the larger a company’s FCCR ratio is, the less risky it will be to lend money to that business. This is because higher FCCRs correspond to businesses with more revenue to allocate for covering debt payments and are therefore less likely to default. In addition to FCCR, we have a guide that discusses other common small business loan requirements.
FCCR ratios can be interpreted as follows:
- Less than 1 indicates that the business doesn’t have enough earnings to cover its fixed costs.
- Equal to 1 mainly indicates that a firm has the available net cash flow to pay for its annual fixed charge once.
- Greater than 1 means the firm has excess available net cash flow to pay for its annual fixed charges (an FCCR of 2 or greater is ideal).
FCCR can also be used as an internal tool for your own company to determine its financial health. It can inform you as to how much of your cash flow is being consumed by fixed expenses. Being aware of this ensures your business does not take on too much debt to fund new projects. Businesses can also track the FCCR over an extended period of time to determine whether it is trending up or down.
Limitations of the Fixed Charge Coverage Ratio
The FCCR is just one of many financial ratios that provide information on the overall health of a company. Given the complexity of a business, however, the FCCR figure won’t always show the full picture.
For example, rapidly growing companies may temporarily have higher loan or lease expenses as a result of business expansion plans. Companies could also decide to pay dividends to stockholders or owners, resulting in a decrease in the FCCR figure.
We recommend using the FCCR ratio in combination with other financial ratios to have a well-rounded view of your company’s health. You can read about other common ratios in our financial ratio analysis guide.
Improving Your FCCR
Businesses looking to improve their FCCR should take steps to improve earnings without significantly increasing costs and by reducing expenses. Here are three ways to improve your FCCR:
- Increase sales without excessive marketing expense: A business owner can review marketing campaigns and reallocate marketing dollars to where they will have a greater sales impact. A business can also improve its team’s sales techniques to close more deals.
- Negotiate better rental or lease rates: Landlords may consider a request for a lower rental rate from long-time renters or lessees, assuming that their payment history is excellent. Better rental or lease rates may require a longer-term commitment; however, this commitment will provide both parties with more stability and improve your bottom line.
- Refinance higher interest rate debt: Consolidating high-interest-rate debts into another loan with a lower interest rate will bring down interest expense. Applying for a business loan is a common approach businesses will take to manage their debt and improve their cash flow.
Frequently Asked Questions (FAQs)
The FCCR is used by lenders to determine if you get approved and at what rates and terms. As a business owner, it can also help you determine the financial health of your company and whether you have sufficient earnings to cover your expenses.
You’ll typically need an FCCR of 1.2 to qualify for most business loans. A ratio of 2 or greater, however, will significantly improve your approval odds.
Your company’s FCCR can be improved by increasing your revenue and/or decreasing your fixed expenses. This can be done by refinancing to more favorable rates and terms and ensuring your company’s marketing resources are being used efficiently to bring in new business.
Bottom Line
Lenders use the fixed charge coverage ratio to determine how financially solvent a business is. The higher the ratio, the healthier the business is. Most lenders require an FCCR of at least 1.2 as a bare minimum, but this figure varies by the industry and scenario a business faces.
By understanding what factors affect this ratio, business owners and managers can make informed decisions to improve their firm’s financial standing and to increase the odds of landing a loan approval.
