What’s it: The fixed charge coverage ratio is a financial ratio to measure how well a company can cover interest and lease payments. Both represent fixed costs, which the company has to pay regardless of whether the company generates revenue or not. We then relate this to earnings before interest and tax (EBIT) to calculate this ratio.
A high ratio means having the ability to pay well, so it is preferable. The company has sufficient profits to pay off the interest on its debts and make lease payments; thus, its financial condition is relatively safe.
Why is the fixed charge coverage ratio important?
Creditors such as banks and bondholders review this ratio to assess a company’s creditworthiness. This ratio tells them how much the company can cover interest and lease expenses. Checking them is important to evaluate and decide whether they are willing to lend money to the company or not.
Interest and lease payments are fixed costs. They give rise to regular cash outflows. The company must pay them regardless of its financial condition or business performance. Thus, when sales volume falls or generates no revenue at all, the company still has an obligation to pay them.
Fixed costs contrast with variable costs, where they go up and down with sales volume. When sales volume falls, variable costs fall. Conversely, when sales go up, variable costs go up.
We then relate interest and lease expenses to a profit measure, namely EBIT. When a company generates relatively high EBIT, its ability to pay these fixed costs is relatively good. Moreover, the higher it is, the more sustainable its ability to pay fixed costs is. Thus, lenders usually will not worry about extending or offering additional debt.
However, if the company is not making enough profit, the company may have problems with payment. As a result, creditors will avoid such companies because the money they lend is unlikely to be repaid.
How do we calculate the fixed charge coverage ratio?
Calculating the fixed charge coverage ratio starts from EBIT. We then add the lease expense and use the result as the numerator. Meanwhile, as the denominator, we use interest expense plus lease expense. Here is the formula for fixed charge coverage ratio:
- Fixed-charge coverage ratio = (EBIT + Lease expense)/ (Interest expense + Lease expense)
Interest expense and lease expense may be found in the income statement. If it is not in the report, we can check it in the notes to the financial statements.
Likewise, companies may present EBIT on the income statement and may not. And, if we don’t find it, we can calculate it manually. So, for example, we can start with net income and then add interest and taxes back together.
In another approach, we calculate EBIT by starting with revenue and subtracting it from the cost of goods sold and operating expenses. We then add the result with non-operating income and subtract it by non-operating expenses (excluding interest and lease expenses).
- EBIT = Net income + Interest expense + Tax expense
- EBIT = Revenue – Cost of goods sold – Operating expenses + Non-operating income + Non-operating expenses (excluding interest and lease expenses)
EBIT is often equated with operating profit. It is true if in the above calculation we exclude non-operating income/expense, whose value often fluctuates from time to time. Non-operating income (expenses) can rise sharply at one time and fall drastically at another time. And to avoid the effect of such fluctuations on the calculated figures, some analysts exclude them.
Now, take a simple example. A company reports an EBIT of $500,000. Meanwhile, the lease and interest payments are $20,000 and $100,000, respectively. From this information, we get a fixed charge coverage ratio of 4.3 times = ($500,000+20,000)/($100,000+20,000).
How to interpret the fixed charge coverage ratio?
A high ratio shows the company has safe finances to pay interest and lease expenses. They have sufficient cash because the profit currently generated can cover those payments. They do not have to withdraw cash and cash equivalents from the balance sheet or apply for new debt to pay them off.
On the other hand, a low ratio is frowned upon because the firm is not generating enough profit to pay interest and lease expenses. For example, suppose EBIT equals interest and lease expenses. In that case, the company will only be able to pay them once with the resulting profit. As a result, its ability to make the same payments in subsequent periods is highly doubtful.
Then, suppose the low ratio is accompanied by insufficient cash and cash equivalent balances. In that case, the company will likely default. That indicates the company is experiencing serious financial problems.
Faced with this situation, management may take strategic steps such as selling receivables to cover payments. Alternatively, they expedite the sale of inventory for cash, for example, by offering discounts or lowering prices. So, they can collect cash faster.
The next option to repay is to apply for a new loan. But, indeed, applying for a new loan can be an expensive alternative. Creditors are likely to charge high-interest rates to compensate for the high risk.
Creditors will usually hesitate to provide loans unless, perhaps, the company offers a guarantee. They will further check whether the company can recover its profits in the future or not. If profits do not recover, they may not be willing to lend money.
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