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Fixed charge coverage ratio (FCCR) shows how well a business’s earnings cover its fixed charges—such as debt payments, lease payments, insurance premiums, and salaries—before interest and taxes are accounted for. A high ratio shows that a business can comfortably cover its fixed costs based on its current cash flow.
When you apply for capital with a lender, they will closely examine your business finances to determine whether you should qualify for the loan. One of the factors a lender might look at is the fixed charge coverage ratio (FCCR). The fixed charge coverage ratio formula helps the lender assess to what extent your business’s fixed costs consume your cash flow.
Lenders work out this calculation because they don’t want to make a bad investment. It is imperative that they know whether or not you will be able to pay back the loan. The fixed charge coverage ratio helps them understand how your earnings are currently being used and the capacity your business has to take on more debt. Read on to see the fixed charge coverage ratio formula and examples of how it’s used.
The fixed charge coverage ratio is important to know when you are applying for business loans. It is also critical information to have when you are considering the overall health of your business. The fixed charge coverage ratio formula is as follows:
(Earnings Before Interest and Taxes (EBIT) + Fixed Charges Before Taxes) / (Fixed Charges Before Taxes + Interest)
Most lenders expect to see a fixed charge coverage ratio of 1.25: 1 or higher. Here’s how to use the fixed charge coverage ratio formula:
A company’s EBIT is also known as the operating income, operating earnings, or operating property. It is calculated by taking the total annual revenue and subtracting the cost of goods sold (COGS) and operating expenses. The operating expenses include things like wages and benefits for employees, plus the cost of research and development. EBIT tells you your business’s net income before income taxes and interest are deducted.
Fixed charges are calculated annually and can include any number of regular charges like lease payments, loan payments, insurance premiums, and employee wages. However, if you deduct rent as part of the operating expenses for your EBIT figure, you will not need to include it as part of the fixed charge. Most of what a business will account for as fixed charges can be deducted as business expenses.
The last variable in the fixed charge coverage ratio formula is interest. Your interest expenses can be calculated by multiplying the total dollar amount of outstanding debt by the interest rate on the debt. It should also appear on your profit and loss statement.
Let’s go over a couple of examples to show how to calculate the fixed charge coverage ratio for your business.
Lisa runs a spa and salon in a small historic town in Georgia. Because her business location is in a more exclusive area of her town, her monthly rent is pretty high. Her monthly expenses include her rent, her insurance both on the salon and also on its vehicle, and her regular interest payments. Her total fixed charges before taxes calculated annually are $30,000. Her annual interest payments are $10,000. On average, the spa’s EBIT for the year was $84,000.
To find Lisa’s fixed charge coverage ratio, add her EBIT and the total fixed charge before taxes and then divide by the fixed charge plus interest. You can see in the image above that this equals 114,000 divided by 40,000. Lisa’s fixed charge coverage ratio is 2.8:1. This means that there should be approximately $2.80 of operating cash flow produced for every $1 of debt incurred. Lisa’s ratio is healthy, as the baseline for a good ratio is 1.25:1 or a ratio of $1.25 to every $1 of debt incurred.
Some financial experts contend that the fixed charge coverage ratio does not take into account significant decreases in cash flow for corporations like S-corps and LLCs. This significant decrease in cash flow can take the form of owner draws or dividends, which is not counted in the standard EBIT. There are several reasons why owners often obtain a large part of their income through dividends or distributions, the primary reason being taxes. Owners will often take draws or dividends to avoid paying payroll taxes. The fact that the standard fixed charge coverage ratio calculation does not take draws into account is an issue for banks because they might be ranking a potential borrower as more creditworthy than they actually are. They do not know how much the owner or owners are receiving in compensation.
If you take an owner draw, use this alternative formula to calculate the fixed charge coverage ratio:
(EBIT + Fixed Charges Before Taxes + Owner Draws) / (Fixed Charges Before Taxes + Interest + Owner Draws)
As an example, let’s turn our attention to Michael and his home theater business.
Michael’s home theater business, located in Orlando, Florida, has annual EBIT of $250,000. He has fixed charges of $48,000 annually, plus he makes annual interest payments of $26,000. His dividend from the company every year is $70,000. To calculate Michael’s fixed charge coverage ratio with the additional owner dividend, we would add $250,000 plus $48,000 plus $70,000 and divide by $48,000 plus $26,000 plus $70,000.
As you can see in the image above, the calculation yields a final fixed charge coverage ratio of 2.5:1 or $2.50 for every $1 of debt incurred. This is another good ratio for a company, especially given that the owner dividend is taken into consideration. It is interesting to note that if the fixed charge coverage ratio was calculated and the loan officer had omitted or had been unaware of the owner draw, the ratio would have been much higher at 4:1. Usually, if a fixed charge coverage ratio is over three, it’s assumed that the company is not using leverage to its maximum potential.
What if you have a 1:1 ratio or a ratio just slightly higher than that? It’s definitely possible to improve your fixed charge coverage ratio, so you can better position yourself to qualify for a loan. In the next example, we will examine a business with a low fixed charge coverage ratio and the steps you can take to remedy the situation.
Beth is a florist living and working in an expensive neighborhood in East Hampton, New York. Her flower shop is located on Main Street in a coveted commercial space. Right now, Beth does not focus her business toward weddings; however, it is her goal to expand in the near future. Her annual rent is $135,000 for a 2,000-square-foot retail space. She also takes an annual dividend of $50,000 and she makes regular interest payments that total $55,000. Beth’s EBIT is $85,000.
Beth’s ratio is 1.13:1, which means she has a $1.13 for every $1 of debt incurred. While Beth is able to cover every debt, she does not have a large cushion to fall back on. If her business goes through a downturn, she might have to dip into her cash reserves. As her ratio stands now, she probably wouldn’t qualify for a business loan from a bank. While a lender will also take into account other ratios and factors, her fixed charge coverage ratio might be enough reason to not grant Beth a loan.
Beth’s next step would be to improve her fixed charge coverage ratio, and there are a few ways to go about this. First, Beth could work to improve her marketing to increase her sales. Partnering with a wedding caterer or bakery means that Beth could expand her florist business without a significant increase in her marketing budget. Beth could also negotiate for a lower rental rate after proving her stability as a renter. This would drop her fixed charges significantly and increase her current ratio. Another step that Beth could take is to consolidate her high-interest payments and perhaps pay them off with a loan that has a lower interest rate. Then, she could attempt to qualify for a new business loan.
As you can see, knowing your fixed charge coverage ratio is essential for the small business owner. Hopefully, through these examples, we have made it easy for you to see how to calculate your own fixed charge coverage ratio. Taking your business to the next level means being aware of all aspects of your business, so it’s important to understand financial ratios, including the fixed charge coverage ratio.
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