Definition:
Fixed Charge Coverage Ratio is one of the Financial Ratios used to measure an entity’s ability to pay interest expenses and fixed charge obligations from its profit before interest and tax.
Fixed charge simply mean assets or similar kind that company use to secured loan that it borrow from the bank.
The assets that the company registers under fixed charge could be sold by an entity unless there is permission from the bank or fixed charge holder.
That is the reason why this ratio is so important for them. The bank use fixed charge contract is just because of security purpose.
However, in some case, the bank use floating charge in the state. Especially when the loan is small or the company being borrow has no bad payment history.
Formula:
(Earning Before Interest and Tax + Fixed Charge Before Tax) / (Fixed Charge Before Tax + Interest Expenses)
Or
Using:
Fixed Charge Coverage Ratio is very importance for banker or lender who provide the loan to the entity.
They assess the possibilities of paying the interest and principal back even if the loan is secure by assets being registered for.
The main important items to calculate these ratios are Earning Before Interest and Tax, Fixed Charge Expenses (Gross), and Interest Expenses.
Earnings before interest and tax are the operating income for the period of time before charging the tax expenses and interest expenses for that period.
There are some argument that why do we to calculate this ratio if the loan is secure by fixed charge already.
A fixed charge is just the type of collateral, and the bank never wants to come into the case that forces its client to sell the assets to get the principal back.
They need to check the ability to pay interest and installment first before they provide. Once the assessment light has shown blue, then it is even more secure to provide. Otherwise, further procedure is required.
Even the Fixed Charge Coverage Ratio could help inventors, bankers, and shareholders on certain things. This ratio also has some disadvantages and limitations.
Basically, this ratio measuring the cash flow of the entity by using financial information. As we all know, financial information could be manipulated by the smart CFO to help the financial statement look even more healthy.
The real cash flow might not be the same as what we see. The cash flow problem might not be because of financial factors but non-financial factors.
I mean that the company could even face a bad cash flow problem because of poor internal control on cash correction. A proper internal control system could help this.
Remember, when the company uses its assets as a fixed charge, it means this company already faces a cash flow problem. The ratio you analyzing just to get some idea from it. Do not use this ratio as the sole factor for decision-making.
Example:
ABC is the company operating in cloths manufacturing. Due to the increase in operation, ABC plans to set up two new products line.
The loan to set up this product line is in consideration. The bank requires 500,000 USD of fixed assets to be considered as Fixed charges.
The financial information for ABC for the year ended 31 December 2015 is as follow:
- Profit Before Interest and Tax 400,000
- Interest Expenses amount 20,000
- Lease Payment amount 50,000
Calculate Fixed Charge Coverage Ratio for ABC.
Answer:
As you can see, the Financial Information for ABC is
- Profit Before Interest and Tax 400,000
- Interest Expenses amount 20,000
- Lease Payment amount 50,000
This three items are importance for our calculation,
The formula for our calculation is
(Earning Before Interest and Tax + Fixed Charge Before Tax) / (Fixed Charge Before Tax + Interest Expenses)
Base on this formula, Fixed Charge Coverage Ratio is 6.43 time (400,000 + 50,000) / (50,000 + 20,000)
Written by Sinra
