Table of Contents
The fixed charge coverage ratio (FCCR) measures a business’s ability to pay for its recurrent expenses, such as mandatory debt payments, rent, utilities, interest, and equipment leases, with its current earnings.
Key Points
• The fixed charge coverage ratio (FCCR) indicates a business’s ability to pay its fixed expenses with its earnings.
• Formula for FCCR: EBIT + fixed charges before taxes / fixed charges before taxes + interest
• Lenders often look for an FCCR of at least 1.2 before approving a loan.
• Improving FCCR involves refinancing debts, reducing overhead, and negotiating lower lease payments.
• FCCR complements other financial metrics in assessing a business’s creditworthiness.
Fixed Charge Coverage Ratio (FCCR) Explained
The fixed charge coverage ratio shows how a business can meet its expected financial responsibilities. A company’s FCCR is one of the lending ratios a bank might consider when deciding whether to extend small business loans.
What It Measures
The FCCR shows how easily a business can satisfy its fixed charges. These are predictable, recurrent business expenses that must be paid regardless of sales volume, such as lease payments or debt obligations.
A low FCCR can mean the company has less capacity to make payments fully and on time, which poses a risk for lenders. A high FCCR indicates that a company can adequately cover fixed charges based on its current earnings.
Calculating your business’s FCCR may be a part of the break-even analysis you do when assessing the health of your enterprise.
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How It’s Calculated
There is a formula for calculating the FCCR. To use it, you’ll need to know some financial details about the company, such as its earnings before taxes and interest, its fixed charges, and how it is categorizing its business expenses.
Fixed Charge Coverage Ratio Formula
To do the calculation, use the fixed charge coverage ratio formula, as follows:
| Fixed charge coverage ratio = |
EBIT + fixed charges before taxes
fixed charges before taxes + interest
|
EBIT stands for earnings before interest and taxes, and as the name suggests, you arrive at that figure by adding tax and interest expenses back into your company’s net income. You can find the EBIT figure on the company’s income statement, sometimes referred to as operating income.
To calculate FCCR, you add the business’s interest costs, lease payments, and other fixed charges back in, as shown above. It can also be helpful to understand the EBITDA formula, a related metric that adds depreciation and amortization to the EBIT, when assessing your FCCR.
How Lenders Use the FCCR to Evaluate Businesses
The FCCR is a key factor for lenders when evaluating businesses’ loan applications. A ratio of 1 means the business has just enough earnings before taxes and interest to meet its financial responsibilities. A ratio of 2 means that company earnings would enable the business to pay for its financial responsibilities two times over. The ideal FCCR varies by industry, but many lenders want to see businesses that have a ratio of at least 1.2.
However, certain factors aren’t addressed by the FCCR, so lenders also use other benchmarks in evaluating a business’s creditworthiness. They may look at your debt-to-EBITDA ratio, for example.
Another is the debt service coverage ratio (DSCR). Unlike the FCCR, the DSCR ratio focuses only on debt repayment and doesn’t include fixed financial obligations.
The DSCR is calculated using EBITDA, divided by the total debt service interest and principal. Therefore, the larger your debt is, the lower your DSCR will be. This calculation is worth keeping in mind if you’re considering applying for a business line of credit or additional loans.
Improving Your Fixed Charge Coverage Ratio
There are ways to improve a company’s fixed charge coverage ratio over time. While these changes may not immediately fix your FCCR, they’re likely to help the company’s finances regardless:
• Refinancing the business’s existing debts into a lower interest rate can lower the company’s interest payments and raise the FCCR.
• Reducing or relocating overhead could also lower the business’s overall costs in order to increase EBIT. This would result in a larger numerator for the FCCR formula, leading to a higher ratio.
• Buying used equipment is generally cheaper than buying or leasing new equipment. Since lease payments and EBIT are part of the FCCR, this could improve the company’s FCCR. Check with your accountant: You may even be able to write off the used equipment as a small business tax deduction.
• Negotiating a lower interest rate or lower lease payments are other ways to lower the company’s fixed charges, increasing EBIT and thereby the company’s FCCR.
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The Takeaway
The fixed charge coverage ratio (FCCR) measures how well a business can pay for its fixed expenses, including debt payments, rent, utilities, interest, and equipment lease expenses. Lenders and investors often use FCCR as a factor in approving a business for loans or investment opportunities. It should help raise your company’s FCCR over time if you can find ways to increase revenue, pay down debt, and lower expenses.
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FAQ
What is a good fixed charge coverage ratio?
In general, the higher the fixed charge coverage ratio (FCCR), the better, but the ideal FCCR varies by industry. Many lenders want to see businesses that have an FCCR of at least 1.2. Companies with a ratio above 2 have the best chances of getting approved for a loan.
How does FCCR differ from the debt service coverage ratio?
The debt service coverage ratio (DSCR) measures a company’s ability to meet its debt obligations from its operating cash flow. It focuses only on debt repayment and, unlike the fixed charge coverage ratio, it doesn’t include other fixed financial obligations. The DSCR uses EBITDA (earnings before taxes, interest, depreciation, and amortization) as a proxy for cash flow.
How can I improve my fixed charge coverage ratio?
Improving your company’s fixed charge coverage ratio is possible. Options include refinancing the business’s existing debts with a lower interest rate, reducing or relocating overhead, buying used equipment, and negotiating better loan terms or smaller lease payments.
Is FCCR important for small businesses?
The fixed charge coverage ratio (FCCR) can be an important factor for small businesses that want to be approved for loans, lines of credit, or other forms of financing. Also, outside investors often consider FCCR when assessing investment opportunities.
Can FCCR affect loan approval?
Yes, the fixed charge coverage ratio (FCCR) can affect loan approval. A lender may see a business with a low FCCR as too risky for a loan. However, most lenders do look beyond FCCR in their analysis.
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