Fixed Charge Coverage Ratio

Fixed charge coverage ratio is a solvency ratio which measures a company's ability to meet its fixed financial obligations. Typically, fixed charge includes interest payments and lease payments. Hence, fixed charge coverage is calculated by dividing the sum of earnings before interest and taxes and lease payments by the sum of interest payments and lease payments.

Fixed charge coverage ratio is similar to interest coverage ratio in concept. The only difference is that fixed charge coverage ratio takes into account the annual obligations on account of lease payments and any other fixed charges too in addition to interest payments. In this sense, the fixed-charge coverage ratio is a relatively more conservative measure of a company's debt-paying ability than interest coverage ratio.

Even though there is no single fixed coverage ratio benchmark which can be used for all companies, a fixed charge coverage ratio should be more than 1. A ratio less than 1 highlights significant solvency problems. Just like any other ratio, fixed charge coverage should be analyzed in the context of a company's industry and complemented by other debt-utilization ratios such as debt ratio, financial leverage ratio, etc.

Formula

The basic formula for fixed charge coverage ratio is as follows:

Fixed Charge Coverage =
EBIT + Fixed Charges
Interest Payments + Fixed Charges

Fixed charges generally refer to all such financial obligations other than interest payments which are fixed in nature. Total lease paymentsa are the most common fixed charges, but some people only include the lease-related interest payments (estimated at 1/3 of the lease payments) in the fixed charges. In this case, only 1/3 of the lease payments are included in both the numerator and denominator. Some practioners also include principal repayments, pension obligations, etc. as part of fixed charges. Hence, it is important to understand the calculation methodologpy before reaching conclusions based on fixed charge coverage ratio.

Example

Nile Inc. has the following figures for financial year ended 31 December 2012. Calculate the interest coverage and fixed coverage ratio using interest and lease payments.

USD in million
EBT500
Interest expense (including interest expense on capital lease obligation)70
EBIT570
Interest income12
Interest payments (related to other than capital leases)55
Operating lease rentals paid40
Capital lease rentals paid (hint: both principal and interest)50
Interest on capital lease included in payments10

Solution

Lease payments = $40 million + $50 million = $90 million

Interest payments plus lease payments = $55 million + $90 million = $145 million

Fixed charge coverage = ($570 million + $90 million) ÷ $145 million = 4.55

Please note that interest income is not taken into account because gross interest payments are relevant.

The lease payments added back above include the interest expense paid on capital lease obligations. The whole interest expense including the portion related to capital lease is already included in the EBIT. Adding it again by not subtracting it from lease payments, overstates the numerator by double-counting interest expense on capital leases.

A more refined calculation is given below:

Lease payments excluding interest on capital leases = $90 million − $10 million = $80 million

Fixed charge coverage = ($570 million + $80 million) ÷ ($145 million - $90 million + $80 million) = 4.81

Since the difference is minor, you can ignore this minor adjustment.

Written by Obaidullah Jan, ACA, CFA and last modified on