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Fixed Charge Coverage Ratio

Description: A company may have such a high level of fixed financing costs that it cannot survive a sudden downturn in profits.  The fixed charge coverage ratio can be used to see if this is the case.  It summarizes a company’s fixed financing commitments, such as lease and interest payments, and divides them into a modified form of earnings before interest and taxes.  A fixed charge coverage ratio close to one reveals that a company must use nearly all of its cash flows to cover fixed financing costs, and is a strong indicator of future problems if profits drop.

Formula: To calculate the fixed charge coverage ratio, add the lease expense to earnings before interest and taxes (EBIT), and divide by the sum of the interest expense and lease expense. The types of financing expenses and other payments that are fixed can be subject to some interpretation; for example, if a lease is close to expiring, there is no need to include it in the formula, since it is a forward looking measure, and there will be no lease payments in the future.  The fixed charge coverage formula is as follows:

(Earnings before interest and taxes) + lease expense
Interest expense + lease expense

Example: Aruba Bungee Cord (ABC) Company records earnings before interest and taxes of $400,000 in the preceding year, as well as $100,000 in lease expenses and $75,000 of interest expense.  Its fixed charge coverage calculation is:

$400,000 EBIT + $100,000 lease expense
$75,000 interest expense + $100,000 lease expense

=

Fixed charge coverage ratio = 2.86

Cautions: Some charges may be included or excluded, depending upon the uses to which the ratio is to be put, so be aware of any excluded finance costs.