Fixed-Charge Coverage Ratio

Posted in Finance, Accounting and Economics Terms, Total Reads: 574
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Definition: Fixed-Charge Coverage Ratio

It is a financial ratio which can be used to determine the ability of the firm to pay its fixed charges through its income before interest and income tax. Fixed charges are a major component of the firm’s expenditure so much of the firm’s cash flow is consumed by it.


It is calculated as

= (EBIT + Fixed Charge (Before Tax)) / (Fixed Charge (before tax) + Interest)

 

Example

A firm may have taken a huge loan so it has to pay a large amount of interest so in this case fixed charge coverage ratio can be used to determine how large the problem is.

The fixed charge coverage ratio can be used to determine the effect of any type of fixed cost e.g. Lease payments, preferred dividend and insurance payments.


If a company has $15,000 as EBIT and $3,000 as lease payments and $3,000 as interest payments then the fixed charge coverage ratio can be calculated as

Fixed charge coverage ratio = (15,000+3,000)/ (3,000+3,000) = 18,000/6000 = 3


This means that the company has earned revenues which are three times its fixed charges.

 

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