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Fixed Charge Coverage Ratio: Definition & Examples

Instructor: Mark Koscinski

Mark has a doctorate from Drew University and teaches accounting classes. He is a writer, editor and has experience in public and private accounting.

In this lesson, learn how to calculate the fixed-charge coverage ratio and where to find the required information to perform the calculation. Understand who uses this ratio, how it is used, and why it is important.

Fixed-Charge Coverage Ratio: Definition & Examples

You are ready to go to the bank and apply for a business loan to expand your production plant and buy more equipment. To prepare for the meeting, you ask your accountant what is needed to impress the banker favorably. He tells you a key piece of information the bank will ask for is the fixed-charge coverage ratio. You ask him how to calculate this ratio and where to obtain the necessary information. It is critical not only to understand how to calculate this ratio, but you must know why the bank would ask for this information.

What Is the Fixed-Charge Coverage Ratio?

The fixed-charge coverage ratio is a very popular measure of a company's ability to pay all of its fixed charges with its income before interest and income taxes (IBIT). Lenders especially like this ratio because it demonstrates financial strength. It is also popular with other users of financial statements such as analysts. They use this ratio extensively since any fixed expenditures such as the lease, debt, and all other fixed payments can be accounted for in the ratio.

How to Calculate the Fixed-Charge Coverage Ratio

The ratio is calculated in the following manner:

Fixed-charge coverage ratio=income before interest and taxes + fixed charges/fixed charges + interest expense

Where Does the Information for the Numerator and the Denominator Come From?

There are several pieces of financial information needed to calculate the fixed-charge coverage ratio. Fortunately, all of them are included in the financial statements of the company. The numerator begins with IBIT, which can be derived from the company's income statement. It is then adjusted for any fixed charges. Fixed charges, a key number in both the numerator and the denominator, can be a little harder to find. First, we need to define a few terms.

Variable and Fixed Costs

A variable cost or variable charge is one that increases or decreases with volume. Cost of goods sold (COGS) is one example. As sales volume goes up or down, you would expect COGS to rise or fall as well. A fixed cost or fixed charge is one that does not increase as volume increases. Examples include the property tax paid on all company facilities, rent on office equipment and interest expense. You may need to read the financial statements and the footnotes as well as the income statement to determine what fixed charges the company must pay. If the ratio is being prepared internally, management has a much easier time determining what the fixed charges are since it is intimately familiar with the details of the company's costs and payments.

What Does the Fixed-Charge Coverage Ratio Tell You?

The fixed-charge coverage ratio demonstrates your company's ability to make its fixed payments. It shows how easily a company can pay its bills when they come due. A company that cannot make its rent or debt payments will not survive very long. The fixed-charge coverage ratio is usually expressed as a number rather than a percentage. The higher the number, the better off the company is and the safer any lender will feel. Lower ratios will make lenders and other creditors nervous.

So for instance, you will hear ''Company X has a fixed coverage ratio of five times.'' This company can pay its fixed charges five times over from its IBIT, a pretty healthy ratio by any standard. It is important to compare your fixed-charge coverage ratio to other companies in the industry. This is the best gauge of how well your company is doing against your competitors.

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