Fixed-Charge Coverage Ratio

Definition

The Fixed-Charge Coverage Ratio (FCCR) is a financial metric used to evaluate a company’s ability to handle its fixed-charge obligations such as interest expenses and leases. It measures how comfortably the company can pay these obligations from its earnings before interest and taxes (EBIT). A higher FCCR indicates that the company has a higher cushion to cover its fixed costs, implying lower financial risk.

Phonetic

The phonetics of the keyword “Fixed-Charge Coverage Ratio” is as follows:Fixed: /fɪkst/Charge: /tʃɑːrdʒ/Coverage: /ˈkʌvərɪdʒ/Ratio: /ˈreɪʃiːoʊ/

Key Takeaways

<ol><li>The Fixed-Charge Coverage Ratio is a solvency ratio that measures a company’s ability to cover its fixed charges, such as interest and lease expenses, with its earnings before interest and taxes (EBIT). This ratio is important as it helps creditors, lenders, and investors determine how effectively a company can handle its fixed costs.</li><li>A high Fixed-Charge Coverage Ratio indicates that the company has a stronger solvency and is more likely to meet its obligations, assuming its earnings remain consistent. This implies that the company is less risky to creditors and investors.</li><li>Conversely, a low Fixed-Charge Coverage Ratio may signify that a company is struggling to cover its fixed expenses using its operational earnings, which could indicate financial instability. In such cases, the company may be a higher risk for lenders, creditors, and investors.</li></ol>

Importance

The Fixed-Charge Coverage Ratio is important in business/finance because it provides an assessment of a company’s financial solidity and its ability to meet its fixed charge obligations such as interest and lease expenses. It is a solvency ratio that measures the firm’s ability to cover its fixed charges (expenses that are not dependent on the level of output) on an annual basis, both interest, lease payments, and whether enough income is being generated for this purpose. Therefore, the higher the ratio, the more capable the company is in handling its fixed charge obligations. Investors, lenders, and analysts often use this ratio to determine the financial health and performance of a company.

Explanation

The Fixed-Charge Coverage Ratio is a financial metric predominantly used by credit rating and lending agencies to assess a company’s solvency or its ability to meet fixed financial obligations such as interest payments and leases. The ratio demonstrates how comfortably a firm can cover these fixed charges from its earnings before interest and taxes. It provides a measure of the risk inherent in a firm’s structure by expressing the proportion of income that can be used for covering fixed costs. The higher the fixed-charge coverage ratio, the more cushion the company has to handle these expenses without redirecting resources from other areas of operation or resorting to external financing.Employing this ratio is beneficial for stakeholders in making calculated investment decisions. It promotes an understanding of a company’s financial health, by evaluating the potential risks and rewards. Lenders and investors analyze the application of the fixed-charge coverage ratio to forecast the company’s ability to comfortably cover its fixed charges. This is particularly useful during the times of financial instability or downturn as it reflects how susceptible the firm may be to negative market conditions. Therefore, alongside other financial ratio analyses, the fixed-charge coverage ratio provides a comprehensive insight into the firm’s financial competency and resilience.

Examples

1. Corporation ABC in the Manufacturing Sector: Corporation ABC, an industrial firm, borrows a significant amount of capital to fund its operations. Usually, the company has to make annual payments of $2 million for its loan interest and lease obligations. Corporation ABC earns an EBIT (Earnings Before Interest and Taxes) of $8 million and pays a yearly depreciation expense of $1 million. To calculate their fixed-charge coverage ratio, ABC would add their EBIT and lease expenses ($8 million + $2 million), then divide that sum by their total fixed charges ($2 million + $1 million). Corporation ABC therefore has a fixed-charge coverage ratio of 2, meaning it earns twice the money needed to cover their fixed charges.2. Automobile Manufacturer Inc: Automobile manufacturer Inc has a large factory lease and yearly interest on its loans that amounts to $5 million. The company’s EBIT is $15 million and the company pays yearly amortization charges of $1 million. To calculate the fixed-charge coverage ratio, the EBIT is added to the lease payments ($15 million + $5 million), and divided by the total fixed charges ($5 million + $1 million). The result is a ratio of 2.86, which indicates the company’s robust ability to cover its fixed costs considering its current earnings.3. Retail Company XYZ: Retail Company XYZ leases numerous storefront locations and also has loans that require payments amounting to $3 million each year. It makes $6 million yearly before paying interest and taxes and also incurs a depreciation of $500,000 annually. By adding the EBIT to the lease payment ($6 million + $3 million), and dividing by the sum of the lease payment and amortization charges ($3 million + $500,000), it results in a fixed-charge coverage ratio of 1.5. This implies that Retail Company XYZ is only just meeting its obligations and could potentially face problems if its profitability decreases.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Interest Expense
• Earnings Before Interest and Taxes (EBIT)
• Operating Leverage
• Debt Service Coverage
• Financial Solvency

Sources for More Information

• Investopedia
• Corporate Finance Institute
• Accounting Tools
• Finance Formulas