The fixed charge coverage ratio (FCCR) is derived from a formula that calculates 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, or the ability to pay debts, and the ratio is used by lenders and investors to evaluate a firm’s ability to cover its fixed costs regularly.
An FCCR of 2.0 or above gives your company the best chance to get a small business loan with a reasonable interest rate. Most lenders require a minimum FCCR of 1.2 to qualify for financing.
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Fixed Charge Coverage Ratio Formula
Earnings before interest and taxes + Fixed charges before tax
Fixed charges before tax and interest
How to calculate fixed charge coverage ratio:
- Step 1: Combine earnings before interest and taxes with fixed charges before tax.
- Step 2: Divide the sum in Step 1 by the combined total of fixed charges before tax and interest.
Fixed charges, or fixed expenses, are items a business must pay regardless of activity. Examples of fixed charges are lease, loan, and insurance payments. Any fixed charges that are about to expire can be disregarded from the calculation.
Earnings Before Interest & Taxes
Earnings before interest and taxes (EBIT) measures a company’s profit and includes all expenses except interest and income tax. EBIT can be computed either via the direct or indirect method.
- Direct method: Take total revenue and subtract your cost of goods sold (COGS) and operating expenses from it.
- Indirect method: Work back from net income by adding interest and taxes.
Interest expense is a nonoperating expense reported on a company’s income statement. It is calculated by taking the outstanding balance of any borrowings multiplied by the interest rate.
What Does the FCCR Tell You?
The FCCR indicates the number of times a company’s earnings can cover its fixed expenses per year. It is often used in qualifying a business for a loan, helping lenders determine how easily a business can pay its obligations when they become due. It is most commonly applied when a company has incurred a large amount of debt and must make ongoing interest payments.
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.
Here’s how to analyze and evaluate your FCCR:
- 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
- Equal to 2 means the firm can pay for twice its annual fixed costs
This is an indication of cash flow to the lender. An FCCR ratio of less than 1.2 increases the risk to the lender as it shows a business might not have the cash to pay back its debts.
Businesses should also be aware of their net working capital ratio, which is another indication of solvency that is used by lenders when considering repayment ability.
Limitations of the FCCR
An FCCR of at least 2.0 shows that a business is financially healthy and at low risk of insolvency. However, a low FCCR doesn’t always mean the firm is in poor financial shape. To analyze the ratio effectively, you should compare the current FCCR to your company’s historical performance and similar businesses in the 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. Another example is a business that takes funds out of earnings to pay one of its owners or pay dividends to stockholders could see its ratio decrease.
Your company has:
- EBIT: $300,000
- Lease payments: $120,000
- Interest expense in the prior year: $20,000
The FCCR calculation would be:
FCCR = ($300,000 in EBIT) + ($120,000 in fixed charges) ÷ ($120,000 in fixed changes) + ($20,000 interest expense)
FCCR = ($300,000 + $120,000) ÷ ($120,000 + $20,000)
FCCR = $420,000 ÷ $140,000
FCCR = 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
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 it 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/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 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.
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 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 to improve their firm’s financial standing.