Fixed Charge Coverage Ratio

Fixed charge coverage ratio is the most meaningful ratio out of all the coverage ratios from a general point of view. It is basically a ratio of earnings to total fixed liabilities. Since it covers all the fixed liabilities, its coverage is wider compared to other ratios such as debt service coverage ratio, dividend coverage ratio, interest service coverage ratio etc.

Fixed charge coverage ratio, as suggested by its name, is a ratio in relation to the fixed charges. In this reference, fixed charges are generally referred to finance charges and therefore the ratio is also known as finance charge coverage ratio apart from total fixed charge coverage ratio. Fixed charges are those charges in any business which occur irrespective of the revenues and other things. They are fixed by their nature and do not change with a marginal increase in the activity of the business. Here, the fixed charges mean the interest charge, lease payments, preference dividend, installments of a loan, etc.
We can easily understand with the example that with the increase in revenues of the business, the interest charges on loans (say) does not change.

Fixed Charge Coverage RatioHow to calculate Fixed Charge Coverage Ratio (FCCR)?

The calculation of total fixed charge coverage ratio requires many figures from the profit and loss statement. The items which need to be ascertained from the P/L statement are EBIT, Lease Payments (if any), Interest, Preference Dividend Payments, Installments of Principal, and tax rate. The formulae for total fixed charge coverage ratio are as follows:

Total Fixed Charge Coverage Ratio (TFCCR)

=

EBIT + Lease Payments


Interest + Lease Payment + {(Preference Dividend + Installment of Principal) / (1- Tax Rate)}

  • Earnings before Interest and Taxes (EBIT): PAT is generally available readily on the face of the Profit and loss account. It is the balance of the profit and loss account which is transferred to the reserve and surplus fund of the business. Sometimes, in the absence of the profit and loss statement, we can also find it on the balance sheet by subtracting the current year P/L account from the previous year’s balance, which is readily available under the head of reserve & surplus.
  • Lease Payments:
    Lease payments are the total amount of lease rentals paid or payable in the current financial year under concern.
  • Interest: It is also the amount of interest on loans paid or payable in the financial year under concern.
  • Preference Dividend: It is the total amount of dividend which is distributed to preference shareholders in the concerned year.
  • Installment of Principal: Total amount of loan is distributed over the term of the loan to be paid by the business. The part which is accrued or paid in the current year is considered as an installment of principal.
  • Tax Rate: It is the rate of tax relevant for the business. The rate varies with the countries in which the operations are based. The rates are monitored by the government of the respective country.

Note:

Why we divide the Installment and Preference Dividend by (1-Tax Rate)?

The installment and preference dividend is divided by (1- Tax Rate) because the installment and dividend are not tax deductible expenses of a business. A business cannot claim dividend and installment as an expense against the profits of the company. They are paid out of the net earnings of the company. Here in our formulae, we have taken EBIT as our earnings and therefore to convert our denominator comparable to the numerator, all the fixed charges are converted into before tax items.

Interpretation of Total Fixed Charge Coverage Ratio

The interpretation of the ratio is very simple. Higher the ratio better is the financial position of the business. Lower ratios are not appreciated for the financial health of a business. It is because the lower ratio suggests the incapability of the business to sustain against the fixed charges. In simple words, the company or the firm is not earning enough to pay off the liabilities and thereby create a risk of bankruptcy.

As far as a benchmark is considered, the first danger line is a ratio of 1. If a company has a ratio of less than 1, it means that the company is not able to serve its debts or fixed charges and it bound to fail. Normally, this ratio is utilized when a loan or working capital limit is to be sanctioned by a bank or financial institution and also in the case of rating agencies who rates the companies for different purposes such as bond rating, general rating etc.

It is always advisable to look for details of the calculation of the ratio because the utility of the ratio can be hampered if the numerator or the denominator is affected by some abnormal ways like including depreciation in the earnings. Why depreciation can affect the utility is because ultimately the fixed charges have to be met from the cash available but not from the profits which may contain non-cash items like depreciation.

Last updated on : August 31st, 2017
What’s your view on this? Share it in comments below.

Leave a Reply

Asset Turnover Ratio (ATR)
  • Inventory /Stock Turnover Ratio
    Inventory / Stock Turnover Ratio
  • How to analyze and improve Current Ratio
    How to analyze and improve Current Ratio?
  • Piggybank Surrounded In Coins Showing European Savings
    Cash Ratio
  • Capital Gearing Ratio
    Capital Gearing Ratio
  • Subscribe to Blog via Email

    Enter your email address to subscribe to this blog and receive notifications of new posts by email.

    Join 122 other subscribers

    Recent Posts

    Find us on Facebook


    Related pages


    payout ratio analysisdividend irrelevancysalary is direct or indirect expensemeaning and definition of capital budgetingtrue lease vs operating leaseadvantages of double entry accountingroa financedisadvantages of capital asset pricing modelowners equity meansmeaning of lease in marathius gaap research and developmentroa formulaasset turnover ratio meaningshareholder vs stockholderselling debenturesfinancial statement adalahdebentures as a source of financelevaragesaverage roceaccounting for installment salesfactoring advantages and disadvantagesebit vs net incomemodified dupont formuladefinition of preference sharesforeign exchange exposure and risk managementaverage dscrwacc book valuedisadvantages of operating leasemarginal costing formatequity valuation dcffull recourse factoringreceivable discountingcalculating irr by handhard capital rationingdefine giverdividend growth model definitionstock turnover period formuladiscounted cash flow stock valuationcapitalizing software development costsliquid assets calculationcost ratio formuladupont formula exampledifference between loan and lendcapital structure and waccis marketable securities a current assetbootstrapping in mergers and acquisitionssundry meaning in accountingloss on revaluationdouble entry system advantages and disadvantagesbank overdraft accounting definitiondefinition of solvency ratiocan private company issue debentureshypothecation agreementpbp capitalhow to calculate intrinsic value of common stockexplain wacchorizontal mergers definitionturnover vs revenuedefine receivables turnovershareholder or stakeholderearning per share equationbill discountingtypes of dividend policy theoryinventory turnoversformula for discountingreceivable turnover in dayswhat is an installment sales contractlimitation of capm modelmeaning of profit maximisationassociated bank overdraftfinance lease vs operating lease accountingmaximise profitssteps in zero based budgetingstock turnover formuladebenture certificatesformula for credit sales