Fixed Charge Coverage Ratio
Definition of Fixed-Charge Coverage Ratio
Fixed charge coverage ratio is the ratio that indicates a firm’s ability to satisfy fixed financing expenses such as interest and leases. This means that the fixed charges that a firm is obligated to meet are met by the firm. This ratio is calculated by summing up Earnings before interest and Taxes or EBIT and Fixed charge which is divided by fixed charge before tax and interest.
Formula used for calculating Fixed Charge Coverage Ratio
The formula used for calculating fixed charge coverage ratio is as follows:
(EBIT + Fixed charge before tax) / (Fixed charge before tax + Interest)
Where, EBIT is Earnings before interest and taxes.
EBIT, taxes and the interest expenses are to be taken from the income statement of the company. The lease payments are taken from the balance sheet, usually appearing as a footnote of the balance sheet. The result that is obtained by finding out the fixed charge coverage ratio is the number of times the company is able to meet its fixed charges per year. The greater the number of times the company can pay its charges the better it is for the firm as the debt position of the firm is proportional to the interest earned ratio.
The above formula can be explained with the help of an example:
For example, a company has $13,000 as EBIT and $2,000 as lease payments and $1,000 as interest payments the fixed charge coverage ratio is measured as:
Fixed charge coverage ratio = (13,000+2,000)/(1,000+2,000) = 15,000/3000 = 5
This means that the company has earned five times its fixed charges, the company is able to pay the fixed charges of the company.
Therefore this means that by calculating the fixed charge coverage ratio, it helps in ascertaining the company’s ability to pay the various fixed costs of the company incase the business tends to fall. Every business would have its own share of risks involved and every company must be well prepared to handle all the expenses and losses that can occur to the company. This is why it is important to calculate the fixed charge coverage ratio and it enables a business to understand the loss or expense taking capacity of the business in case some misfortune strikes the company. This ratio like all other ratios can provide a basic idea of the standing of the company’s finances based on the historical data provided to you. Therefore it is important that you determine fixed charge coverage ratio to ascertain the standing of the company.