Fixed-Charge Coverage Ratio

Fixed-Charge Coverage Ratio is a financial ratio that measures a firm’s ability to pay its fixed expenses, such as interest and lease payments, from its operating income. In other words, it evaluates a firm’s ability to cover fixed costs using its cash flows before considering any taxes or debt payments.

It helps investors, lenders, and creditors assess a firm’s financial health and creditworthiness. It measures its capacity to meet its fixed costs from its cash flow. A higher FCCR ratio shows a firm generates sufficient cash flow to cover fixed costs. This is the reason it is considered more financially stable and less risky. A lower FCCR ratio, on the other hand, shows that a firm may struggle to meet its fixed financial obligations. As a result, it is considered to be more financially risky.

• Fixed-Charge Coverage Ratio is a financial ratio that assesses a firm’s ability to cover fixed expenses. For example, its operating income includes lease payments, insurance, and salaries.
• FCCR divides a firm’s earnings before interest and taxes (EBIT) and fixed charges by its fixed costs and interest expenses.
• A higher FCCR ratio shows that a firm generates sufficient cash flow to cover fixed expenses and is more financially stable and less risky. On the other hand, a lower FCCR ratio suggests that a firm may struggle to meet its fixed financial obligations.

The Fixed-Charge Coverage Ratio is a financial ratio that assesses a firm’s ability to cover fixed expenses from its operating income. Fixed expenses include cost payment which is a must irrespective of sales levels, like lease payments, insurance, and salaries. The FCCR calculates a firm’s earnings before interest and taxes (EBIT) and fixed charges by its fixed costs and interest expenses.

The FCCR originated as a tool for lenders and creditors to evaluate a firm’s creditworthiness before lending money or extending credit. The significance of the FCCR lies in its capacity to measure a firm’s financial stability and risk level. A higher FCCR ratio shows that a firm generates sufficient cash flow to cover expenses and is financially stable and less risky. This can improve a firm’s ability to secure loans and credit and attract potential investors. On the other hand, a lower FCCR ratio suggests that a firm may struggle to meet its fixed financial obligations and may be seen as a more financially risky investment.

The formula for calculating the Fixed-Charge Coverage Ratio is as follows:

FCCR = (EBIT + Fixed Charges) / (Fixed Charges + Interest Expense)

The FCCR formula consists of two parts: the numerator and the denominator.

The numerator is the sum of a firm’s earnings before interest, taxes (EBIT), and fixed charges. EBIT represents a firm’s operating income, which is the money it generates from its regular business operations before considering interest and taxes. Fixed charges are expenses that must be paid irrespective of sales levels, like lease payments, insurance, and salaries.

The denominator is the sum of the firm’s overhead charges and interest expense. Interest expense refers to the interest paid on outstanding debt. By dividing the numerator by the denominator, the FCCR calculates how often a firm’s cash flow can cover its fixed charges and interest expenses. A ratio of greater than one shows that the firm is generating sufficient cash flow to cover fixed costs. In contrast, a percentage of less than 1 means that the firm may struggle to meet its financial obligations.

Let us understand it in the following ways.

Example #1

Let's say that firm RedRock has an EBIT of $500,000, fixed charges of $100,000, and interest expense of $50,000. Using the FCCR formula, we can calculate the firm’s Fixed-Charge Coverage Ratio as follows:

FCCR = ($500,000 + $100,000) / ($100,000 + $50,000)

          = $600,000 / $150,000

          = 4

In this example, Firm RedRock's FCCR is 4, which generates enough cash flow to cover fixed expenses and interest payments four times over. This shows that the firm is financially stable and is capable of meeting its financial obligations.

Example #2

In the 2021 10-K filing, Delta Air Lines, Inc. reported a fixed-charge coverage ratio of 1.4, indicating that Delta's cash flow was sufficient to cover fixed charges and interest expenses 1.4 times over. This ratio improved from the previous year when Delta reported an FCCR of 1.2.

Delta's higher FCCR ratio suggests that the firm was able to manage its fixed expenses better and generate more robust cash flows in the face of the COVID-19 pandemic, which significantly impacted the airline industry. Investors and creditors may use this information to evaluate Delta's financial health and creditworthiness when considering investments, loans, or credit extensions to the firm.

Fixed Charge Coverage Ratio and Debt Service Coverage Ratio (DSCR) are financial ratios that assess a firm’s ability to meet its financial obligations. Here are some of the differences:

1. Definition: FCCR measures a firm’s ability to cover fixed expenses from its operating income, while DSCR measures its capacity to repay its debt obligations from its active income.
2. Components: FCCR includes fixed charges and interest expenses, while DSCR only considers the firm’s debt obligations, including principal and interest payments.
3. Calculation: The formula for calculating FCCR is (EBIT + Fixed Charges) / (Fixed Charges + Interest Expense), while the procedure for DSCR is (EBITDA / Total Debt Service).
4. Scope: FCCR is a narrower measure of a firm’s ability to meet financial obligations, as it only considers fixed expenses and interest payments. At the same time, DSCR believes in a firm’s total debt obligations.
5. Application: Lenders and creditors may use both ratios to evaluate a firm’s creditworthiness, but they may place more emphasis on DSCR when assessing a firm’s ability to repay its debts, as it directly measures its capacity to meet its debt obligations.

This has been a guide to what is Fixed-Charge Coverage Ratio. We explain it with its formula, comparison with the debt service coverage ratio, and examples. You can learn more about it from the following articles –

• Asset Coverage Ratio
• Coverage Ratio
• Interest Coverage Ratio