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Fixed Charge Coverage Ratio Definition

Fixed Charge Coverage Ratio Definition

Fixed Charge coverage ratio, defined as a measure of how well a company can meet its fixed financial obligations (such as interest and leases) with its operating profit, also serves as a measure of the ability of a company to pay bills owed. It indicates the financial risk involved in paying fixed costs within a company’s business operation. This ratio acts as a risk indicator.

In a sense, the Fixed Charge Coverage Ratio allows a company, as well as outside companies, to know if a business can fulfill its financial obligations. Within the company, the fixed charge coverage ratio allows a company to fully understand the capabilities of the organization. More specifically, it allows the company to understand what projects can be undertaken and which projects must be scrapped for another time. More accurately put, the fixed charge coverage ratio is a strong indicator of how successful a company is going to be, both from inside the company and from the outside looking in.

Fixed Charge Coverage Ratio Explanation

Fixed charge coverage ratio, explained, is a strong indicator of a company’s future problems if sales drop to any extent. It is especially important for a company who spends heavily on leases. The lower the operation profit, the worse negative effects of fixed payments will become. For example, a company will feel heavier burden of lease payments combined with interest expense with declining sales. At the same time, this could deter possible outside investors to support a company with a negative fixed charge coverage ratio.

Though the ratio is just a numerical figure, the implications of this number have important effects on a company. Though, it is not completely impossible to improve a company’s fixed charge coverage ratio. As a company improves its ability to pay bills and debts, the ratio will improve. If a company’s ratio is not quite as good as they would like, it is beneficial to at least show a positive trend in where the ratio is headed.

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fixed charge coverage ratio definition

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fixed charge coverage ratio definition

See Also:
Fixed Charge Coverage Ratio Analysis
Financial Ratios
Key Performance Indicators (KPIs)

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Fixed Charge Coverage Ratio Analysis

See Also:
Fixed Charge Coverage Ratio Definition
Operating Income (EBIT)
Debt Service Coverage Ratio
Fixed Costs
Times Interest Earned Ratio
Free Cash Flow
Financial Ratios

Fixed Charge Coverage Ratio Analysis Formula

See the fixed charge coverage ratio analysis formula below:

Times Interest Earned Ratio = (EBIT + fixed charge) ÷ (total interest + fixed charge)

Fixed Charge Coverage Ratio Calculations

Fixed charge coverage ratio calculations can be simple or difficult depending on the complexity of the associated financial information. For example, a company has $ 16,000 in EBIT, $ 1,000 in interest payments and $2,000 in lease payments.

Fixed charge coverage ratio = (16,000 + 2,000) / (1,000 +2,000) = 8

This means that a company has earned eight times its fixed charges.


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Fixed Charge Coverage Ratio Example

For example, Ron owns a small business which provides artisan-quality roofing services to upscale homes. Ron has carved a unique niche for his company over time. He is proud of his achievements and satisfied customer base.

Recently, the recession has caused Ron to see less jobs for Spanish tile roofing. With this serving as the bread-and-butter of Ron’s company, he wants to be prepared for additional dips in his revenues due to less sales.

Ron, essentially, wants to perform fixed charge coverage ratio analysis to assure that his company can survive the recession.

Ron speaks to his controller and performs the following equation. Ron’s company has $ 16,000 in EBIT, $ 1,000 in interest payments and $2,000 in lease payment. So…

Fixed charge coverage ratio = (16,000 + 2,000) / (1,000 +2,000) = 8

After speaking with his controller, Ron is confident that his company can survive an extended recession. He needs to check he has not violated his fixed charge coverage ratio covenant (bank requirement) for his bank loan.

Ron’s company controller looks at the agreement. Ron, after a little work, realizes that his company has not violated a covenant. Despite the fact that Ron’s company has an acceptable fixed charge coverage ratio, EBITDA will remain the same for his covenants with the bank to stay unbroken. Ron respects the value of keeping up-to-date with financial statements, as well as bank agreements, thanks to the hand of his company accountant.

fixed charge coverage ratio analysis

Resources

For statistical information about industry financial ratios, please click the following website: www.bizstats.comand www.valueline.com.

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