Do You Know Your Fixed Charge Coverage Ratio?
Usually when someone mentions a company’s coverage ratio, they’re referring to the ability of the business to pay its debt obligations. Specifically, they’re referencing a financial metric known as the times-interest-earned ratio. But, a company has more fixed obligations than its principal and interest loan payments. The fixed charge coverage ratio includes all of a company’s fixed obligations–not just its debt service coverage.
What are a Company’s Fixed Charges?
Every business has fixed obligations they must regularly meet, regardless of sales volume or profits. Here are a few of the fixed obligations in addition to loan payments that most companies have to make:
Insurance premiums covering vehicles and property
Rent for offices and warehouses
Licenses and fees
Employee wages and salaries
Lease payments on equipment
A company’s cash flow must be enough to at least pay these obligations or it could go out of business.
What is the Fixed Charge Coverage Ratio?
The fixed charge coverage ratio, FCCR, shows the ability of a business to pay all its recurring fixed charges before deductions for interest and taxes. The formula to calculate the FCCR is as follows:
Fixed Charge Coverage Ratio = (Earnings before interest and taxes [EBIT] + Fixed charges before taxes)/(Fixed charges before taxes + interest)
Let’s illustrate with an example. Suppose Company A has an EBIT of $110,000, interest charges of $10,000 and other fixed obligations of $115,000 before taxes (leases, insurance and salaries). Its FCCR would be as follows:
FCCR = ($110,000 + $115,000)/($115,000 + $10,000) = 2.0
The FCCR shows the amount of the company’s cash flow that fixed costs consume. In the case of Company A, an FCCR of 2.0 means the company generates $2 in EBIT for each $1 in fixed costs.
How do Lenders Use the FCCR?
Lenders use FCCR to gauge a business’s financial health and ability to repay its loans. They want to know that a company can meet all its obligations even if sales decline.
Generally, lenders prefer an FCCR of at least 1.25:1. Higher ratios mean that the company can more comfortably cover its fixed costs with its current cash flow. It also shows that the company can take on more debt and still meet its obligations. An FCCR less than one means the business does not have enough earnings to cover its fixed costs. In this case, the owner could be forced to dip into reserve savings to cover the deficit.
How Can a Small Business Owner Use FCCR?
A business owner can use it to learn where the company currently stands and look for ways to improve. Tracking the FCCR over time will let you see if the company’s financial health is improving or declining.
You should know your FCCR before submitting a loan application. An FCCR of 1.25:1 makes lenders less inclined to offer a loan. As a result, you’ll know that you need to improve your FCCR.
If your FCCR is low, you could look at ways to improve marketing and increase sales. Or, on the other hand, you could analyze fixed costs to see if any expenses could be reduced. Owners can use this information to find which projects they can pursue without straining the business’s financial resources. Constructing various “what if” scenarios of different loan arrangements and the effects of changes in revenues and expenses will let you see the resulting FCCRs in the future.
Besides a high FCCR helping you to get financing, it is also assuring to you and your employees to know that the business is healthy and on a solid base for growth.