Fixed Charge Coverage

Fixed charge coverage is a solvency ratio that measures whether earnings before interest, taxes and lease payments are sufficient to cover the interest and lease payments. It is calculated by dividing the sum of earnings before interest and taxes and lease payments by the sum of interest payments and lease payments.

Fixed charge coverage ratio is very similar to interest coverage ratio. The only difference is that fixed charge coverage ratio takes into account the annual obligations on account of lease payments too (in addition to interest payments).

The higher the ratio, the better is the solvency situation of the company. The ratio is best used together with other solvency ratios such debt ratio, financial leverage ratio, etc.

Formula

 Fixed Charge Coverage = EBIT + Lease Payments other than Interest Portion Interest Payments + Lease Payments

Example

Nile Inc. has the following figures for financial year ended 31 December 2012. Calculate the interest coverage and fixed coverage ratio using interest and lease payments.

USD in million
EBT500
Interest expense (including interest expense on capital lease obligation)70
EBIT570
Interest income12
Interest payments (related to other than capital leases)55
Operating lease rentals paid40
Capital lease rentals paid (hint: both principal and interest)50
Interest on capital lease included in payments10

Solution

Lease payments = $40 million +$50 million = $90 million Interest payments plus lease payments =$55 million + $90 million =$145 million

Fixed charge coverage = ($570 million +$90 million) ÷ $145 million = 4.55 Please note that interest income is not taken into account because gross interest payments are relevant. The lease payments added back above include the interest expense paid on capital lease obligations. The whole interest expense including the portion related to capital lease is already included in the EBIT. Adding it again by not subtracting it from lease payments, overstates the numerator by double-counting interest expense on capital leases. A more refined calculation is given below: Lease payments excluding interest on capital leases =$90 million − $10 million =$80 million

Fixed charge coverage = ($570 million +$80 million) ÷ \$145 million = 4.48

Since the difference is minor, you can ignore this minor adjustment.

Written by Obaidullah Jan, ACA, CFAhire me at