Fixed charge coverage ratio: Overview, definition, and example
What is fixed charge coverage ratio?
The fixed charge coverage ratio (FCCR) is a financial metric used to assess a company's ability to meet its fixed financial obligations, such as interest payments, lease payments, and other non-variable costs. It is calculated by dividing the company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) by its fixed charges. This ratio helps investors, creditors, and analysts understand how easily a company can cover its fixed financial obligations from its operational income.
The fixed charge coverage ratio is important because it measures a company’s financial health and its ability to manage debt and other fixed costs. A higher ratio indicates a greater ability to meet fixed obligations, while a lower ratio can signal financial distress or the need for better cash flow management.
Why is fixed charge coverage ratio important?
The fixed charge coverage ratio is important because it provides insight into a company’s financial stability and solvency. By understanding how well a company can cover its fixed obligations, stakeholders can assess the company's ability to avoid default, secure financing, or make strategic decisions regarding investments, expansion, or cost management.
For businesses, maintaining a healthy FCCR is crucial for sustaining operations, managing debt obligations, and maintaining investor and creditor confidence. For lenders, a strong fixed charge coverage ratio reduces the risk associated with lending, as it indicates that the company is generating enough income to cover its fixed costs.
Understanding fixed charge coverage ratio through an example
Imagine a company that has an EBITDA of $10 million for the year and fixed charges totaling $4 million, which include interest payments and lease expenses. The fixed charge coverage ratio would be calculated as follows:
FCCR = EBITDA / Fixed charges
FCCR = $10 million / $4 million = 2.5
This means that the company generates 2.5 times the income needed to cover its fixed charges, indicating that it is in a relatively strong position to meet its financial obligations.
In another example, a company has an EBITDA of $5 million and fixed charges of $6 million. The FCCR would be:
FCCR = $5 million / $6 million = 0.83
This lower ratio suggests that the company may struggle to meet its fixed financial obligations, indicating potential liquidity issues or the need for cost-cutting measures.
An example of a fixed charge coverage ratio clause
Here’s how a fixed charge coverage ratio clause might look in a loan agreement:
“The Borrower agrees to maintain a fixed charge coverage ratio of no less than 1.5:1 during the term of this Agreement. The Borrower shall provide quarterly financial statements to the Lender, demonstrating compliance with this requirement. If the Borrower fails to meet the minimum FCCR, the Lender may request corrective action or accelerate the repayment of the loan.”
Conclusion
The fixed charge coverage ratio is a valuable tool for assessing a company’s ability to meet its fixed financial obligations, such as interest payments and lease expenses. By evaluating the ratio, businesses, investors, and lenders can better understand the company’s financial health, its capacity to handle debt, and its overall stability. Maintaining a strong FCCR is essential for ensuring operational continuity, securing financing, and avoiding financial difficulties.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.