The Fixed Charge Coverage Ratio (FCCR), also known as the Solvency Ratio, shows how well a business can meet its fixed charges and commitments. The FCCR is one of the measures used by lenders when they’re deciding whether to provide your business with a loan. Learning how to calculate and optimize your business’s FCCR gives you insight into the health of your organization and can increase your chances of loan acceptance and favorable terms.
We’ll explain what the FCCR is, how it works, how to calculate it, and how to optimize yours.
What is the Fixed Charge Coverage Ratio?
The FCCR compares the total amount of money your business takes in against the fixed charges that your business needs to pay out. This shows the financial commitments that your business has and its ability to meet those regular payments.
Is a High or Low Fixed Charge Coverage Ratio Better?
Generally, the higher your FCCR, the better. High FCCRs mean that less of your business revenue is being used to make fixed payments, resulting in more free cash flow, and a greater ability to take on more financial commitments. A low FCCR means that much of your revenue is going to meet existing costs, meaning there’s less ability for you to take on additional payments.
An FCCR less than one shows your business cannot currently make its fixed payments. Ideally, your FCCR should be two or above. Lenders may also regard FCCRs of 1.25 and below as problematic, as even a small drop in earnings could create issues with repayments.
What Are Fixed Charges?
For the purpose of the FCCR, a fixed charge is:
- Predictable—it remains the same or varies very little each time it becomes due.
- Recurring—it is an expense that a business needs to pay on a regular basis.
- Fixed—the charge is not linked to the amount of business or revenue.
Examples of fixed charges might include:
- Existing loan repayments
- Existing charges to service debt
- Rent, lease, or mortgage payments
- Salaries paid to staff
- Insurance premium payments
Fixed charges are separate and distinct from variable charges. Variable charges change from period to period, often based on business activity, for example purchasing stock or paying for shipping.
How Do Lenders Use the Fixed Charge Coverage Ratio?
For lenders, the FCCR is one financial measurement that shows how likely they are to have a loan repaid. Businesses with a high FCCR have less of their revenue currently committed to fixed charges, leases, and loan repayments. This means they will typically have more free cash flow that can be used to make regular, timely repayments. Lenders don’t use the FCCR in isolation—it’s just one indicator of the financial health of a business.
A healthy FCCR can also tell a lender that a company is borrowing money to finance faster growth, rather than using the cash to get through hard times. Survival may not provide much incentive to lend, whereas growth will.
How Do You Calculate the Fixed Charge Coverage Ratio?
Firstly, you will need to gather some information, normally from your company’s income statement:
- Get your total “Earnings Before Interest and Taxes”
- Get your total “Fixed Payments”
- Get your “Interest Expenses”
Next, you can calculate the FCCR as follows:
- Add together your Earnings Before Interest and Tax and your Fixed Charges to get a total, “A.”
- Add together your Fixed Charges and your Interest Expenses to get a total, “B.”
- Divide A by B.
- The result is your FCCR.
Here’s an example:
- Earnings Before Interest and Taxes: $250,000
- Fixed Payments: $50,000
- Interest Payments: $15,000
- Total A: $300,000 ($250,000 + $50,000)
- Total B: $65,000 ($50,000 + $15,000)
- FCCR: 4.62 ($300,000 / $65,000)
A note of caution:
It’s important not to “double count” your fixed costs, or you will get an erroneous FCCR. Some aspects of fixed costs, like salaries or insurance premiums are likely to already be included in your Earnings Before Interest and Taxes figure. In those cases, do not add them to your fixed costs or you will be figuring them into the formula twice. Depending on accounting rules, it may just be your lease expenses that are not already included, so check with your accountant.
How Can Company Management Use the Fixed Charge Coverage Ratio?
The FCCR is a helpful benchmark to understand the financial health of the business. You can use the FCCR prior to investing in new projects that will raise fixed costs or taking on new leases for property, equipment, or other purposes.
How Can I Improve my Fixed Charge Coverage Ratio?
There are several techniques a business can use to enhance FCCR.
Maximize Earnings Before Interest and Taxes
- Increase selling prices to create more revenue.
- Use various methods to reduce expenses and costs.
- Reduce hidden costs in your business.
- Understand and maximize profit margins.
- Take advantage of discounts.
Minimize Lease Costs
- Negotiate new rates with leasing companies.
- Take advantage of prepayment.
- Take advantage of discounted rates for longer-term leases.
Reduce Interest Payments
- Pay off high-interest loans as soon as possible.
- Renegotiate high-interest loans with your current lender.
- Refinance high-interest loans.
Understanding your FCCR and getting it in order will help to maximize your chances of being accepted for a small business loan. Good luck!