The fixed charge coverage ratio is used to examine the extent to which fixed costs consume the cash flow of a business. The ratio is most commonly applied when a company has incurred a large amount of debt and must make ongoing interest payments. If the resulting ratio is low, it is a strong indicator that any subsequent drop in the profits of a business may bring about its failure. Conversely, a high ratio indicates that a business can safely use more debt to fund its growth. The ratio is typically used by lenders evaluating an existing or prospective borrower.
To calculate the fixed charge coverage ratio, combine earnings before interest and taxes with any lease expense, and then divide by the combined total of interest expense and lease expense. This ratio is intended to show estimated future results, so it is acceptable to drop from the calculation any expenses that are about to expire. The formula is:
((Earnings before interest and taxes) + Lease expense) ÷ (Interest expense + Lease expense)
For example, Luminescence Corporation recorded earnings before interest and taxes of $800,000 in the preceding year. The company also recorded $200,000 of lease expense and $50,000 of interest expense. Based on this information, its fixed charge coverage is:
($800,000 EBIT + $200,000 Lease expense) ÷ ($50,000 Interest expense + $200,000 Lease expense)
= 4:1 Fixed charge coverage ratio