The Fixed Charge Coverage Ratio (FCCR) indicates a firm’s ability to pay its fixed charge obligations (expenses) from its income before interest and taxes. It determines the extent to which recurring charges consume the company’s cash flow. The ratio derived from the computation is the number of times a firm can cover its fixed expenses each year.
Fixed charges (or fixed costs) need be paid regardless of the sales revenues, and this ratio is a test to find out if the firm has enough earnings to do so. Stated another way, the FCCR measures solvency and how easily a firm can cover its recurring expenses. Lenders and investors use this ratio to evaluate a business’ financial state.
Fixed Charge Coverage Ratio (FCCR) Formula
Earnings before interest and taxes + Fixed charges before tax / Fixed charges before tax + Interest
- Combine earnings before interest and taxes with fixed charge before tax (if any)
- Divide by the combined total of fixed charge before tax and interest.
- It is acceptable to drop any expense that’s about to expire.
Fixed charges, or fixed costs, are business expenses that need to be paid regardless of business activity. Unlike variable costs, fixed costs don’t increase as sales volume increases. Conversely, this cost doesn’t decrease when sales decrease. Examples of fixed charge are lease payments, loan payments, and insurance payments. They are typically found on the income statement as operating expenses.
Earnings Before Interest & Taxes (EBIT)
EBIT is a measure of a firm’s profit that includes all expenses except interest and income tax expenses. It focuses on operating results which makes it similar to operating income.
- How to Determine Your EBIT – EBIT can be computed in two ways. The direct method begins by taking total revenue and subtracting from it your cost of goods sold and operating expenses. The indirect method is done by working back from net income, adding in your interest and taxes.
Records the amount of interest incurred on a company’s debt during a period of time. It is a non-operating expense that can be found in the income statement, and computed by taking the outstanding balance of any borrowings multiplied by the interest rate.
Analysis of Fixed Charge Coverage Ratio
As mentioned earlier, the fixed charge coverage ratio refers to a firm’s solvency. It indicates the number of times its earnings can cover its fixed expenses per year. The resulting computation is a simple number which tells lenders how easily a business can pay their obligations when they become due.
Here’s how to analyze and evaluate your FCCR:
- An FCCR less than 1 indicates that the business has not earned enough during the year to cover their 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 annual fixed costs twice over.
The higher the number generated by the formula, the better a firm’s cash position is. The ideal FCCR vary from one industry to another but most lenders commonly consider 1.25 as a threshold to consider a business creditworthy.
However, a low FCCR doesn’t always mean that the firm is in poor financial shape. In order to effectively analyze the ratio, it has to be taken into context in comparison to the firm’s historical FCCR and to similar businesses in the industry. For instance, a rapidly growing startup may have an increase in current assets (e.g. because they are leasing equipment or taking a loan to expand the business) and a decrease in earnings, which will lower the FCCR.
Application of FCCR
The fixed charge coverage ratio (FCCR) is used to examine the extent to which fixed costs consume the cash flow of a business. The ratio is most commonly applied when a company has incurred a large amount of debt and must make ongoing interest payments.
For investors and creditors, the fixed charge coverage ratio is a risk indicator, and determines the firm’s ability to pay its current recurring expenses before they consider lending to or investing in the business.
As an internal tool, 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 the business’ resources to the limit. It also can evaluate business performance by comparing current FCCR to historical values.
Advantages of FCCR
- Provides a solid basis for assessment of a company’s ability to handle its current level of financing.
- Includes lease payments in addition to interest payments on financing which provides a better point of evaluation compared to other financial ratios like financial leverage ratio and interest coverage ratio.
Disadvantages of FCCR
- It disregards significant changes in working capital that can occur in a rapidly growing company. A company that’s quickly growing is characterized by an increased use of cash to invest in inventory and expansion. This can cause a negative change in working capital which reduces cash flow, and thereby, earnings and the FCCR. In this case, the FCCR may not give an accurate representation of a business’ financial state.
- The core formula doesn’t take into account significant cash flow changes from owner draws or dividends that lets business owners withdraw funds from the company without paying payroll taxes. This results in a higher FCCR.
3 Ways to Improve Your Fixed Charge Coverage Ratio
As discussed earlier, the real goal is to manage the ratio so that it registers a rising trend, or keep the ratio within industry averages for similar companies by managing working capital. Improving your fixed charge coverage ratio concentrates on taking steps to improve earnings without a significant increase in costs. The idea is to identify the expenses involved in the computation of FCCR and find ways to lower them. Another is to develop a strategy to improve sales that involve minimal cost.
Here are 3 ways on how to improve your FCCR:
1. Increase sales in less expensive ways.
There are a number of ways to increase a company’s sales without incurring significant costs. For instance, a business owner can review their marketing campaigns and revise their strategy to get better quality leads. They can also focus on improving their team’s sales techniques to close more deals. Collaborating with other non-competitor businesses for sales and marketing campaigns can also decrease budget requirements.
2. Negotiate for a lower rental or lease rates.
Most often than not, landlords or lessors will consider a request for a lower rental rate from long time renters/lessees, assuming that their payment history is spotless. Negotiating lower payments here will lower your fixed charge and improve FCCR.
3. Refinance loans with high interest rates.
It’s not unusual for a firm to pay off a loan with another loan if the interest rate is significantly lower. A business owner can review its loans and consolidate those with high interest rates and refinance it by taking another loan with lower interest rates.This will bring down interest expense which is a factor in determining FCCR.
The acceptable fixed charge coverage ratio (FCCR) varies from industry and business requirements, and much of its value is dependent on a firm’s historical data. By understanding what factors affect this ratio, business owners and managers can make informed decisions that will improve their firm’s financial standing.