Financial Management Concepts in Layman's Language

Fixed Charge Coverage Ratio

By on January 30, 2011 in Financial Analysis with 0 Comments

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 ratio such as debt service coverage ratio, dividend coverage ratio, interest service coverage ratio etc.

Fixed Charge Coverage Ratio

Fixed Charge Coverage Ratio

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.

How 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 absence of the profit and loss statement, we can also find it from 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 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 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 in 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.

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