Fixed-Charge Coverage Ratio Definition

Fixed-Charge Coverage Ratio Definition

What is the fixed cost coverage rate (FCCR)?

The fixed cost coverage ratio measures a company’s ability to cover its fixed costs, such as debt payments, interest expense and equipment rental costs. It shows how well a company’s profits can cover its fixed expenses. Banks often take this ratio into account when assessing whether to lend money to a business.

Key points to remember

  • The FCCR shows to what extent a company’s profits cover its fixed costs.
  • Lenders often use the fixed cost coverage rate to assess the credit worthiness of a business.
  • A high ratio result shows that a company can adequately cover fixed costs according to its current profits.

The formula for the fixed cost coverage rate is as follows:

The

FVSVSR=EBIT+FVSBTFVSBT+Ior:EBIT=earnings before interest and taxesFVSBT=fixed charges before taxI=interest begin {aligned} & FCCR = frac {EBIT + FCBT} {FCBT + i} \ & textbf {where:} \ & EBIT = text {profit before interest and taxes} \ & FCBT = text {fixed costs before tax} \ & i = text {interest} \ end {aligned}

TheFVSVSR=FVSBT+IEBIT+FVSBTTheor:EBIT=earnings before interest and taxesFVSBT=fixed charges before taxI=interestTheThe

How to calculate the coverage rate for fixed costs

The calculation to determine the capacity of a business to cover its fixed costs begins with the profit before interest and taxes (EBIT) in the company’s income statement, then adds interest expense, rental costs and other fixed costs. Then, the adjusted EBIT is divided by the amount of fixed costs plus interest. A ratio result of 1.5, for example, shows that a business has $ 1.50 in profit for every dollar of debt it has incurred and that it is in good financial health.

1:46

Fixed cost coverage ratio

What does the fixed cost coverage rate tell you?

The fixed expense ratio is commonly used by lenders looking to analyze the amount of cash available to a business for debt repayment. A low ratio often reveals a drop in profits and could be disastrous for the business, a situation that lenders are trying to avoid.

As a result, many lenders use coverage ratios, including the interest multiplied by interest rate (TIE) and fixed cost coverage ratio, to determine a company’s ability to contract and pay additional debt. A business that can cover its fixed costs at a faster rate than its peers is not only more efficient but more profitable. It is a company that wants to borrow to finance its growth rather than going through a hardship.

The sales of a business and the costs related to its sales and operations constitute the information appearing in its income statement. Some costs are variable costs and depend on the volume of sales over a given period. As sales increase, variable costs also increase. The other costs are fixed and must be paid, whether or not the business has an activity.

These fixed costs may include such things as equipment rental payments, insurance payments, installments on existing debt, and preferred dividend payments.

Example of fixed cost coverage rate used

The objective of the fixed cost coverage ratio is to see to what extent the revenues can cover the fixed costs. This ratio is very similar to the TIE ratio, but it is a more conservative measure, taking into account the additional fixed costs, including rental costs.

The fixed cost coverage rate is slightly different from the TIE, although the same interpretation can be applied. The fixed cost coverage ratio adds the lease payments to EBIT and then divides them by the total interest and lease charges. For example, suppose Company A records EBIT of $ 300,000, lease payments of $ 200,000 and $ 50,000 in interest expense.

The calculation is $ 300,000 plus $ 200,000 divided by $ 50,000 plus $ 200,000, or $ 500,000 divided by $ 250,000, or a fixed cost coverage rate of 2x. The company’s profit is twice as high as its fixed costs, which is low. Like the TIE, the higher the ratio, the better.

Fixed rate coverage rate limits

The FCCR does not take into account rapid changes in the amount of capital for new and growing businesses. The formula also does not take into account the effects of funds taken from profits to pay for an owner’s drawdown or pay dividends to investors. These events affect the ratio entries and can give a misleading conclusion unless other measures are also taken into account.

For this reason, when banks assess the creditworthiness of a business for a loan, they usually look at other benchmarks in addition to the fixed cost coverage rate to get a more complete picture of the business.

Leave a Comment

Your email address will not be published. Required fields are marked *