This article is part of a larger series on Business Financing.
The Fixed Charge Coverage Ratio (FCCR) indicates a company’s ability to pay its fixed charges―also known as fixed expenses―from its earnings before interest and taxes. The FCCR measures solvency (ability to pay debts), and the ratio is used by lenders and investors to evaluate a firm’s ability to cover its fixed costs on a recurring basis.
Fixed Charge Coverage Ratio Formula
Earnings before interest and taxes + Fixed charges before tax
Fixed charges before tax and interest
The FCCR formula involves two steps:
- Combining earnings before interest and taxes with fixed charges before tax
- Dividing by the combined total of fixed charges before tax and interest
Fixed charges, or fixed expenses, are those items that a business must pay regardless of activity. Examples of fixed charges are lease payments, loan payments, and insurance payments. Any fixed charges that are about to expire can be disregarded from the calculation.
Earnings Before Interest & Taxes
Earnings before interest & taxes (EBIT) is a measure of a company’s profit and includes all expenses except interest and income tax. EBIT can be computed either via direct or indirect methods. The direct method begins by taking total revenue and subtracting from it your cost of goods sold (COGS) and operating expenses. The indirect method is done by working back from net income by adding interest and taxes.
Interest expense is a nonoperating expense that’s reported on a business’ income statement. It’s computed by taking the outstanding balance of any borrowings multiplied by the interest rate.
FCCR Analysis & Example
The fixed charge coverage ratio indicates the number of times a company’s earnings can cover its fixed expenses per year. The FCCR is often used in qualifying a business for a loan. It helps lenders determine how easily a business can pay its obligations when they become due. The ratio is most commonly applied when a company has incurred a large amount of debt and must make ongoing interest payments.
Here’s how to analyze and evaluate your FCCR:
- An FCCR of less than 1 indicates that the business doesn’t have enough earnings to cover its fixed costs
- An FCCR equal to 1 mainly indicates that a firm has available net cash flow to pay for its annual fixed charge once
- An FCCR equal to 2 means the firm can pay for twice its annual fixed costs
An FCCR of at least 2.0 shows that a business is financially healthy and at a low risk of insolvency. However, a low FCCR doesn’t always mean that the firm is in poor financial shape. To analyze the ratio effectively, the FCCR is used in comparison to the firm’s historical performance and similar businesses in its industry. For instance, a rapidly growing startup may have an increase in loan or lease costs due to business expansion, which will lower the FCCR.
As an internal tool, the FCCR shows how much of a firm’s cash flow is consumed by its fixed costs. With this information, business owners and managers can identify projects to undertake without stretching financial resources to the limit. It also can evaluate business performance by comparing the current FCCR to historical values.
Your company records EBIT of $300,000, lease payments of $120,000, and $20,000 in interest expense in the prior year.
FCCR = ($300,000 in EBIT) + ($120,000 in fixed charges) /
($120,000 in fixed changes) + $20,000 interest expense)
$300,000 + $120,000 = $420,000
$120,000 + $20,000 = $140,000
$420,000 / $140,000 = 3.0
Based on this example, your company would be considered at low risk for insolvency and financially healthy.
Improving Your Fixed Charge Coverage Ratio
Improving your fixed charge coverage ratio requires taking steps to improve earnings without a significant increase in costs as well as reducing expenses. Here are three ways to improve your FCCR:
- Increase sales without excessive marketing expense: For instance, a business owner can review their marketing campaigns and reallocate marketing dollars to areas where it’ll have a greater sales impact. A business can also focus on improving 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/lessees, assuming that their payment history is excellent. Better rental or lease rates may require a longer-term commitment; however, this commitment will provide more stability for both parties and also improve your bottom line.
- Refinance higher interest rate debt: Consolidating any 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 that businesses will take to manage their debt and improve their cash flow.
The fixed charge coverage ratio is used by lenders to determine how financially solvent a business is. The higher the ratio, the healthier the business is. Most lenders prefer an FCCR of at least 2.0, 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 that’ll improve their firm’s financial standing.