Calculating and Understanding the Fixed Charge Coverage Ratio: Explanation and Implications
The fixed charge coverage ratio (FCCR) is a crucial financial metric that offers insight into a company's ability to meet its fixed financial obligations, such as interest and lease payments. This ratio is particularly significant for creditors, including banks and bondholders, as it helps them assess a company's creditworthiness.
Variable costs, on the other hand, fluctuate with sales volume. In contrast, fixed costs, like interest and lease payments, give rise to regular cash outflows, regardless of the company's financial condition or business performance. These costs can be found in the income statement or the notes to the financial statements.
To calculate the FCCR, one takes Earnings Before Interest and Tax (EBIT) plus lease expense and divides it by interest expense plus lease expense. A high FCCR indicates that the company has sufficient profits to pay off its fixed costs.
Related ratios that offer further insight into a company's financial health include various types of interest coverage ratios and other solvency or leverage ratios.
The Interest Coverage Ratio (ICR) measures how many times a company can cover its interest expenses using EBIT. Variations of this ratio use EBITDA or post-tax earnings (EBIAT) for different analytical perspectives.
The EBITDA Interest Coverage Ratio uses EBITDA instead of EBIT to show coverage of interest payments with operational cash flow before non-cash expenses. The EBITDA Coverage Ratio measures a company's ability to cover loan and lease payments by comparing (EBITDA + lease payments) to (loan payments + lease payments).
The EBITDA Less Capex Interest Coverage Ratio assesses available cash flow after essential reinvestments by subtracting capital expenditures from EBITDA before calculating interest coverage.
The Degree of Financial Leverage (DFL) shows sensitivity of earnings per share to changes in operating income based on capital structure, calculated via EBIT and interest expenses. The Equity Multiplier measures financial leverage by comparing total assets to total equity, indirectly related to the ability to cover fixed charges.
It's important to note that EBIT may not always be presented on the income statement and may need to be calculated manually.
The FCCR itself goes beyond just interest by including all fixed financial obligations such as lease payments and debt repayments, giving a broader view of the company's ability to meet fixed costs from earnings. Higher ratios generally indicate a stronger ability to cover fixed charges and interest payments.
Together, these ratios provide valuable insight into a company's solvency, repayment capacity, and financial risk related to fixed charges and debt servicing.
Investing in a company's business may involve analyzing its financial health through various ratios. For instance, the FCCR helps assess a company's ability to cover its fixed financial obligations, such as interest and lease payments, from its earnings.
Regarding fixed costs, the Interest Coverage Ratio (ICR) measures a company's ability to pay its interest expenses multiple times using EBIT, providing insights into creditworthiness to potential investors.
