## 3.6. Fixed charge coverage ratio

Fixed charge coverage ratio measures the ability of a company to meet its fixed charges (e.g., lease payments). This ratio is calculated by dividing (a) earnings before interest and taxes plus fixed charges before tax by (b) fixed charges before tax plus interest.

The fixed charge coverage ratio shows the number of times the company can cover its fixed charges per year. The higher the number, the stronger the financial position of the company.

Fixed Charge Coverage Ratio Formula

Fixed charge coverage ratio is calculated by dividing the sum of EBIT (earnings before interest and taxes) and fixed charges before tax (e.g., lease payments, debt principal payments) by the sum of the fixed charges before tax and interest:

 Fixed Charge Coverage Ratio = EBIT + Fixed Charges before Tax Fixed Charges before Tax + Interest

Fixed Charge Coverage Ratio Example

Friends Company had \$4,440 in EBIT (refer to a section earlier where EBIT is discussed) at the end of 20X9, \$220 in interest payments and \$2,780 in principal payments (i.e., a decrease in long-term liabilities found on the balance sheet). In this example we assume that the company didn’t have other fixed charges (e.g., lease payments). The fixed charge coverage ratio at the end of fiscal year 20X9 was:

 Fixed Charge Coverage Ratio = \$4,440 + \$2,780 = 2.4 (rounded) \$2,780 + \$220

Therefore, in 20X9 the company could cover its fixed charges 2.4 times.

Important Notes

• Similar to the times interest earned ratio, the higher the fixed charge coverage ratio is, the better.
• Fixed charges may vary and can include a portion of operating lease payments, depreciation, amortization, and debt principal payments. Thus, it is important to understand what is included in fixed charges when analyzing fixed charge coverage ratios to ensure comparability of results.
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