Fixed-Charge Coverage Ratio

Fixed-Charge Coverage Ratio Financial Ratio Corporate Finance Debt Management Earnings Before Interest and Taxes (EBIT) Interest Payments Long-Term Debt Financial Analysis
The Fixed-Charge Coverage Ratio measures a firm's ability to meet its fixed financial obligations, including interest payments on long-term debt and other contractual commitments, relative to its earnings before interest and taxes.
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Definition

The Fixed-Charge Coverage Ratio (FCCR) is a financial metric that assesses a company’s ability to meet its fixed financial obligations. It is calculated by dividing the firm’s earnings before interest and taxes (EBIT) by the total fixed charges, which generally include interest on bonds and other long-term debt. This ratio illuminates how many times the company can cover its interest charges with its operating earnings on a pretax basis.

Formula

\[ \text{Fixed-Charge Coverage Ratio} = \frac{\text{EBIT} + \text{Fixed Charges}}{\text{Fixed Charges}} \]

Key Components

  • EBIT (Earnings Before Interest and Taxes): Represents the company’s profitability excluding interest and tax expenses.
  • Fixed Charges: Consist primarily of interest payments on bonds, long-term debt, and other contractual long-term commitments.

Examples

  1. Example 1:

    • EBIT: $1,000,000
    • Interest on Bonds: $200,000
    • Calculation: \[ \text{FCCR} = \frac{1,000,000}{200,000} = 5 \]
    • Explanation: This means the firm’s EBIT can cover its interest charges 5 times over.

  2. Example 2:

    • EBIT: $500,000
    • Interest on Bonds: $250,000
    • Calculation: \[ \text{FCCR} = \frac{500,000}{250,000} = 2 \]
    • Explanation: The firm’s EBIT can cover its interest charges 2 times over.

Frequently Asked Questions

What is the significance of a high Fixed-Charge Coverage Ratio?

A high Fixed-Charge Coverage Ratio indicates that a company comfortably meets its fixed financial obligations, signaling strong financial health and low risk of default.

What is a good Fixed-Charge Coverage Ratio?

A ratio higher than 1 is generally considered good. Ratios below 1 indicate the company may not generate sufficient earnings to cover its fixed charges, posing a risk of financial distress.

How does Fixed-Charge Coverage Ratio affect investors?

Investors use the FCCR to gauge a company’s financial stability and ability to maintain regular interest payments on its debt, which directly influences investment decisions.

Debt-Service Coverage Ratio (DSCR)

Definition: The DSCR is a measure of a company’s ability to service its debt. It is calculated by dividing net operating income by total debt service.

Interest Coverage Ratio

Definition: This ratio specifically analyzes the firm’s ability to meet interest payments. It is calculated by dividing EBIT by interest expenses.

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)

Definition: EBITDA is a metric used to evaluate a company’s operating performance and profitability before accounting for interest, taxes, depreciation, and amortization.

Online Resources

Suggested Books for Further Studies

  • “Financial Statement Analysis and Valuation” by Peter D. Easton
    • A comprehensive guide to financial statement analysis and valuation techniques.
  • “Principles of Corporate Finance” by Richard A. Brealey and Stewart C. Myers
    • A foundational text on corporate finance principles and applications.
  • “Financial Reporting and Analysis” by Charles H. Gibson
    • Explores the principles of financial reporting and detailed methods for analysis.

Fundamentals of Fixed-Charge Coverage Ratio: Corporate Finance Basics Quiz

### What does the Fixed-Charge Coverage Ratio primarily indicate? - [ ] Company's market value. - [x] Company's ability to meet its fixed financial obligations. - [ ] Company's growth potential. - [ ] Company's stock performance. > **Explanation:** The Fixed-Charge Coverage Ratio measures a company's ability to meet its fixed financial obligations from its operating earnings before interest and taxes. ### Which component is NOT included in Fixed Charges? - [ ] Interest on bonds - [ ] Lease payments - [x] Inventory cost - [ ] Long-term debt commitments > **Explanation:** Inventory cost is not included in Fixed Charges. Fixed Charges typically include interest on bonds, lease payments, and long-term debt commitments. ### How do you calculate the Fixed-Charge Coverage Ratio? - [ ] EBIT / Sales - [x] (EBIT + Fixed Charges) / Fixed Charges - [ ] Net Income / Fixed Charges - [ ] Total Assets / Total Liabilities > **Explanation:** The Fixed-Charge Coverage Ratio is calculated by adding EBIT and Fixed Charges, then dividing by Fixed Charges. ### If a company has an EBIT of $600,000 and Fixed Charges of $200,000, what is the Fixed-Charge Coverage Ratio? - [ ] 2 - [ ] 2.5 - [ ] 3 - [x] 4 > **Explanation:** \\[ \text{Fixed-Charge Coverage Ratio} = \frac{600,000}{200,000} = 4 \\] ### What does a Fixed-Charge Coverage Ratio less than 1 indicate? - [ ] The company is highly profitable. - [x] The company may not generate enough earnings to cover its fixed charges. - [ ] The company has no financial obligations. - [ ] The company's stock price is falling. > **Explanation:** A ratio less than 1 indicates the company may not generate enough earnings to cover its fixed charges, posing a risk of financial distress. ### Why is a higher Fixed-Charge Coverage Ratio generally better? - [ ] It indicates higher sales growth. - [ ] It means the company has fewer competitors. - [x] It demonstrates the company's robust capacity to meet its fixed obligations. - [ ] It leads to lower tax expenses. > **Explanation:** A higher ratio demonstrates the company's robust capacity to meet its fixed obligations, suggesting strong financial health. ### Which financial statement provides the EBIT figure used in Fixed-Charge Coverage Ratio? - [x] Income Statement - [ ] Balance Sheet - [ ] Cash Flow Statement - [ ] Statement of Changes in Equity > **Explanation:** EBIT is found on the Income Statement. ### Can a company with high sales always have a high Fixed-Charge Coverage Ratio? - [ ] Yes, high sales ensure high FCCR. - [x] No, high sales don’t guarantee high FCCR if fixed charges are also high. - [ ] Yes, only sales determine FCCR. - [ ] No, sales do not affect FCCR. > **Explanation:** High sales don’t guarantee a high FCCR if fixed charges are also high, as FCCR depends on the relative size of EBIT and fixed charges. ### What other ratio is Fixed-Charge Coverage Ratio closely related to? - [x] Interest Coverage Ratio - [ ] Debt-Equity Ratio - [ ] Current Ratio - [ ] Return on Equity > **Explanation:** It is closely related to the Interest Coverage Ratio, which also measures a company's ability to pay interest charges. ### What is EBIT? - [x] Earnings Before Interest and Taxes - [ ] Earnings Before Income and Taxes - [ ] Earnings Before Infrastructure and Taxes - [ ] Earnings Before Inventory and Taxes > **Explanation:** EBIT stands for Earnings Before Interest and Taxes.

Thank you for taking an in-depth tour into the Fixed-Charge Coverage Ratio concept and engaging with our informative quiz. Keep advancing your financial acumen!

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Wednesday, August 7, 2024
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