For any prospective investor or business owner who wants to know how well their small business is growing , it can be tough to parse through all the financial data and balance sheet lines to get a clear picture. Maybe you want to just know how much “spare” profit you have compared to fixed expenses. Business owners might need to know this to determine if it’s a good time to expand and open up another store. Meanwhile, investors often need to know this information so they can determine if a certain company will be a smart investment. Fortunately, there’s an easy to use tool you can leverage just for this goal: the fixed-charge coverage ratio. The fixed-charge coverage ratio is a value you can find with a simple formula. It shows how much capital a company has relative to its fixed expenses and can even provide some insight into a company’s management style. However, it’s important to know how and when to leverage the fixed-charge coverage ratio if you want to use it correctly. Let’s break down this formula now.
Basically, the fixed-charge coverage ratio or FCCR is a measurement that shows how well a company can meet any fixed charged financial obligations. These include repeated charges like lease payments, interest payments, and other regular bills or (consistent) costs of doing business. Alternatively, you could consider the fixed-charge coverage ratio to show how well the earnings of a business can cover any fixed expenses. Banks, individual investors, and other lending institutions will often calculate and examine this ratio when determining whether they want to lend money to a given firm. Investors may also use this calculation when deciding whether to fund a new startup .
Before we get into the main fixed-charge coverage ratio formula, here are some important terms you’ll need to understand: EBIT or earnings before interest and taxes is essentially the total operating income of a company before necessary deductions for interest and taxes. It’s not actually what the company has to work with for payments or purchases, of course, since it ignores those aforementioned deductions. Calculating EBIT is pretty easy. Just start with your profit for a given period (like a business quarter) and add back any interest or tax expenses. Fixed costs are any independent and consistent costs necessary for business activity. As fixed costs, companies must pay the same amount at the same time over repeated time periods regardless of their sales. Easy examples of fixed costs include rent for infrastructure, employee salaries, loan principal repayments, and similar expenses. Fixed costs are usually reflected in EBIT by default since they are subtracted from revenue. But you may need to add additional fixed expenses, such as lease payments, since these are not always included in EBIT calculations. Lease expenses , as mentioned, are methods to pay for the use of different business assets like office space, warehouses, and vehicles or other machinery. Companies can lease these expenses and pay fixed monthly rent as opposed to buying the equipment or facilities outright. Interest expenses are any costs incurred by using credit like loans or credit cards . Interest must be paid periodically on any outstanding balance for loans. Many interest expenses are also fixed, which makes them relatively easy to add to your calculations.
Now let’s break down the fixed-charge coverage ratio formula in detail. It’s calculated using the following equation:
Fortunately, all of these values can be found either on your company’s income sheet or on a balance sheet (though, in the case of lease payments, sometimes as a footnote). If you don’t have them, speak to your company’s accountant. By calculating these values, your fixed-charge coverage ratio will result in a basic number indicating how many times a company can cover all of its fixed charges in a given year. If the number is higher, it means the company has more cash with which to pay for its fixed expenses. This also indicates other positive attributes, such as a better debt position.
A company’s fixed-charge coverage ratio can tell lenders or analysts a number of useful things. For starters, it shows how much cash flow a company has for immediate debt repayment. Lower ratios can often indicate things like lower earnings or that a company is about to approach bankruptcy. The fixed-charge coverage ratio also shows how well a company can take on and pay for extra debt. If it has a high ratio, it has extra income it can use for further debts or loans, which may be used for expansion and commercial progress. A high fixed-charge coverage ratio also shows that a company is particularly efficient and profitable at the same time. This is especially true when lenders may perform a fixed-charge coverage ratio analysis on two similar companies and need to determine which ones they want to invest in.
Here’s an example. Say that you had have company with:
Therefore, the resulting calculation will look like this:
This eventually results in an FCCR of exactly 2 (since $500,000 divided by $250,000 equals 2). In this example, the company in question has earnings of two times greater than its total fixed costs. In other words, it's an incredibly efficient and/or profitable company, at least when it comes to managing its expenses and debt. That’s a lot of financial wiggle room, and it’s something future investors will love to see. You can really only get an FCCR like this if you are very smart with purchases and debt repayments, and if your company is doing well with its profits so far.
Generally, a high fixed-charge coverage ratio is something to look for. Higher FCCRs indicate that the company has significantly greater income than its fixed expenses. All of that extra income can then be used for things like business expansion, taking on additional debt, paying off outstanding but not fixed debt, or anything else that might be necessary. Broadly speaking, a high fixed-charge coverage ratio shows exceptional company management and great restraint. It may indicate a generally conservative management style since companies that don’t have tons of outstanding debt, or who can pay back all of their necessary fixed expenses on time with tons of cash to spare, probably don’t take on lots of risky loans in the first place. Business owners can look at high FCCRs and see that their company has a lot of potential for expansion, provided that their profits or income remain roughly the same for the foreseeable future. Note, of course, that fixed-charge coverage ratio is an unsuitable analysis tool for really new startups that are growing their revenue fast. Even if they have relatively stable fixed expenses, their fluctuating income can make any resulting FCCR calculation incorrect or misleading.
No. For all of its strengths and ease-of-use, the fixed-charge coverage ratio formula has a few weaknesses you need to be aware of:
Because of these downsides, banks and lenders will typically use the fixed-charge coverage ratio in conjunction with other analysis tools and formulas. Only by using multiple formulas together can you get a big picture look at a company and get a more holistic view of its financial well-being. Business owners would also be wise to use multiple financial analysis formulas rather than just rely on the FCCR.
Ultimately, the fixed-charge coverage ratio is an excellent way to get a snapshot of a company’s general financial well-being and to see how much free capital they have relative to their fixed costs. Note that it doesn’t always tell you exactly how much cash a company has to spend on expansion or debt repayment, however. Still, you can use fixed-charge coverage ratio to great effect. Contact Seek Capital for more financial advice or to see offers for business loans ! Sources https://www.investopedia.com/terms/f/fixed-chargecoverageratio.asp#:~:text=The%20fixed%2Dcharge%20coverage%20ratio%20(FCCR)%20measures%20a%20firm's,lend%20money%20to%20a%20business . https://corporatefinanceinstitute.com/resources/knowledge/finance/ebit/ https://corporatefinanceinstitute.com/resources/knowledge/finance/fixed-charge-coverage-ratio/