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Understanding the Fixed Charge Coverage Ratio for Small Businesses

A fixed charge coverage ratio (FCCR) measures a company’s ability to meet fixed charges from its earnings before interest and taxes (EBIT). Insurance premiums or lease payments are examples of fixed charges, because the same amount is due each month, no matter how sales revenues are faring. FCCR calculations do not include unpredictable, wildly variable expenses like your business vehicle’s gas, or charges that increase as sales volumes go up. The calculation also includes interest charges related to debt.

The number is calculated by adding the company’s earnings before interest and taxes to its fixed obligations before tax, then dividing that total by the sum of fixed charges before tax plus interest.

The resulting number represents how solvent your company is, with a higher number (2 or above) indicating a healthier, company with less financial risk. A ratio value below 1 means the company has critical problems meeting regular financial obligations, and a drop in earnings could likely doom the company.

How many times over can your small business satisfy your predictable financial responsibilities? An FCCR of 1 shows you have just enough to meet them. A fixed charge coverage ratio of 2 shows you could pay them all twice. Your FCCR also shows how much of your small business’s total cash flow is taken by fixed expenses.

Some parallels from personal finance can also help put the FCCR into context with regard to your credit score. This big-picture view of recurring expenses is also reminiscent of the wisdom to avoid spending more than one-third of your personal after-tax income on renting a home or apartment.

An additional financial solvency ratio, like the fixed charge coverage ratio, is the times interest coverage ratio, which measures a business’s ability to pay its debt obligations. The FCCR, however, is a more complex measure of solvency since it considers numerous expenses beyond interest. Other ratios that lenders will calculate when you apply for loans, in order to get the best understanding of your company’s ability to repay the loan, are the debt service coverage ratio and debt ratio.

Why is your fixed charge coverage ratio important?

The FCCR ratio shows how many predictable expenses you have versus how much you are taking in, so this number, in addition to your FICO SBSS score and other factors, comes into play any time an outside party is making an investment in the business or when a traditional lender is considering an application for financing or an equipment loan.

“If you have a rental payment and you are going to be able to make four months’ rent, presumably you are going to continue to earn while you’re paying [each month’s rent], that means you’re staying four months ahead,” said Kate Porter, principal at Pendragon Accounting. “That’s really good. [Lenders think,] ‘We could lend them quite a bit and they would be able to make their monthly payment without ever breaking a sweat.’”

The ideal FCCR number indicating creditworthiness varies by industry, but most lenders look for at least 1.25.

Conversely, if your FCCR number is low, you’re probably in pretty significant financial stress, Porter said. That doesn’t necessarily mean you won’t get a loan. However, the bank is going to want to know a lot more about what you’re going to do with that money. If you’re consolidating debt, for example, they may approve you.

If you are approved with a lower FCCR, indicating a higher risk borrower, that may also mean getting a smaller loan than you need, or one with higher interest.

But FCCR is not only a matter for lenders. “If you’re applying for any type of funding or investment, this calculation is being done on your behalf on the other side,” Porter said. “The benefit for the business owner [to calculate their own FCCR] is preemptive, to look at the health of your business [and see] ‘What are my chances of approval, and can I even afford it if I get it?’”

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Steps to calculate your fixed charge ratio

To calculate a fixed charge coverage ratio, the formula is:

(EBIT + fixed charges before tax)

———————————————

(fixed charges before tax + interest)

Fill in the quantities on the above fraction. “EBIT” is your business’s annual earnings before interest and taxes, as seen on your balance sheet, and also known as operating income, operating earnings or operating property. To get this number, you start with annual revenue and subtract cost of goods sold (COGS) and operating expenses, which includes employee salaries.

Here, “fixed charges” are anything you can include that’s a recurring and pre-set charge, such as business equipment leases, insurance premiums and internet. Convert those to their annual amounts.

In the bottom row, “interest” refers to interest on debt, in annual amounts. It’s found on the income statement, calculated by multiplying the balance of debts by the interest rate.

Once those values are filled in, divide the amount on top of the fraction by the bottom amount.

Alternately, instead of totaling up all the fixed charges, the FCCR can be calculated for each individual fixed charge to determine the business’s ability to meet these responsibilities.

How to improve your fixed charge ratio

So you’ve calculated your business’s FCCR, and number is too low. What can raise it? Increasing your income would obviously help, but that’s easier said than done.

“Probably the best way that’s controllable is to pay down any kind of expenses that you can,” Porter said.  “A lot of times there are things you can reduce, like loan payments, finance payments. You may have options like paying off invoices more quickly so they don’t earn interest and increase liability. Do your utilities have a fixed payment you can go on that reduces your month-to-month expense?”

Generally carry less debt, she added.  “See if you can put some of those charges in cash and possibly improve the ratio a little bit. It won’t be immediate, but over time it will make your numbers look a lot better. Do as much prepayment of debt as possible.”

Another possible way to improve it is to consolidate debt with a lower-interest APR.

Keep in mind that the FCCR is not a be-all, end-all number about your financial solvency, but one component in a business’s overall profile. It does provide a positive indicator for lenders when a small business pays its fixed expenses at a faster pace than its competition. It’s a good sign of a company that’s borrowing because it’s going to expand, not borrowing to counteract or stave off debt.

However, the calculation process of the FCCR doesn’t take into account the dramatic capital increases and decreases with a fledgling business, which can lead to a low FCCR. But the lenders should also compare your business’s FCCR to historic data across your industry, especially for startups experiencing this phenomenon.

The bottom line

Knowing your small business’s FCCR is important if you need financing or may need it in the future. It’s one piece of the toolkit that lenders use to evaluate a business’s solvency. However, it’s also helpful to know your fixed charge coverage ratio as an informed small business owner, so you can tighten up your operation and work to make it more solvent.

 

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