Checklist Description
This checklist provides explains fixed-charge coverage ratios.
Definition
Fixed-charge coverage is a financial ratio that is used to gauge the quality of a bond issue or the ability of a project to meet its debt repayments. It is calculated by dividing total fixed charges into the net income (or earnings before interest and tax) available for these charges. The fixed charges are gross interest, contractual payments under operating leases, and preference dividends.
Thus, a fixed-charge coverage ratio would look like this:
Fixed-charge coverage = EBIT + Fixed charge ÷ (Fixed charge + Interest)
where EBIT is earnings before interest and tax, and the fixed charge is before tax.
Generally, the greatest fixed charge a company is likely to face is the interest on its debt. However, the fixed-charge coverage ratio assumes particular importance if the company you are evaluating spends heavily on leases, such as leases on buildings and equipment. A lease payment is effectively the same thing as a debt payment, and it should be taken just as seriously. The lower a company’s net income, the greater the negative impact of the lease payments on the ratio.
Overall, the lower the ratio, the worse is the financial position of the company. Bond issues can contain covenants that set limits on how low the fixed-charge coverage ratio can fall. Such a covenant is designed to provide the lender with protection, so that the borrower’s financial position will remain more or less the same as it was when the loan was made. Thus, a bond may contain a covenant that prevents the fixed-charge coverage ratio from falling below 2.
Advantages
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The fixed-charge coverage ratio is readily identifiable.
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It provides a straightforward measure of the financial health of a company.
Disadvantages
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There is no standardized procedure for determining either fixed charges or the net income available for these charges.
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Other ratios may provide a better indicator of a company’s financial health.
Action Checklist
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Identify the fixed-charge coverage ratio from the company’s accounts.
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If it is less than 1, speak to the company’s managers immediately to ascertain how they plan to meet their fixed-cost obligations.
Dos and Don’ts
Do
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Remember that if a company has a fixed-charge coverage of less than 1, it cannot meet its fixed obligations through earnings and thus must rely on other funds, such as extra borrowings or drawing down working capital.
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Remember that this ratio often comes into play if you have a working-capital loan; the lender will insist that a specific fixed-charge coverage ratio is maintained or your loan will be recalled.
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Remember to try to gauge the attitudes of managers toward taking on more debt as the existing debt matures.
Don’t
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Don’t just rely on the fixed-charge coverage ratio. Other ratios that can be used to measure a company’s ability to meet its debt obligations include the interest coverage ratio and the debt service coverage ratio.
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Don’t ignore the proforma coverage ratio. It has essentially the same components as the fixed-charge coverage ratio but is forward looking. It can tell you whether this year’s earnings (if repeated) would be able to cover what must be paid in the coming year.
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