How to Calculate Fixed Interest Coverage Ratio? What is a Fixed Interest Coverage Ratio?

What is a Fixed Interest Coverage Ratio?

The fixed interest coverage ratio helps to analyze the company’s wealth. The ratio is used to check whether the company can pay its important bills, like loans, interest, and leases. Overall, the company's financial health is tested through this ratio.

This ratio helps to understand if a company can manage its debts and bills. The higher this ratio, the company's wealth increases, and it’s doing well. It can pay all the debts and bills easily. But if this ratio is low, it means the company is struggling to pay its debts and bills. So, the FCCR is like a tool to see if a company is financially strong enough to borrow more money.

How to Calculate Fixed Interest Coverage Ratio?

Find Earnings Before Interest and Taxes (EBIT): It is like calculating the overall amount of money a company earned before interest and tax reduction. It’s just the full amount a company earns throughout the year.

Find the Fixed Interest Expense: This is the amount of money the company has to pay regularly for its loans. To understand simply, it’s like the amount an individual pays for rent, just as the companies pay a fixed amount for their loans.

Do the math: Once you find out these numbers, you can calculate the fixed interest coverage ratio. Simply divide the EBIT by the fixed interest expense.

The formula used is:

Interest Coverage Ratio = EBIT / Interest Expense

Where: 

EBIT=Earnings before interest and taxes​

Example:

Let’s assume a company’s EBIT is $20,000 and its fixed expense is $2,000. Just by dividing, you get the ratio.

$20,000 ÷ $2,000 = 10. 

From this value, we can understand that the company earns a good profit if the ratio is higher. But if the company has a low ratio, it is struggling to pay back its loan.

What is a Good and Bad Fixed Interest Coverage Ratio?

A good ratio describes the company as earning well and being able to pay its loans and debts. If the ratio is one or greater than one, the company is doing well and making more money. But if the company has a fixed interest coverage ratio of less than 1, then it is struggling to pay its basic loans and bills.

Constraints of the Fixed Interest Coverage Ratio

• It will not account for sudden changes in the amount of money needed by new startups.
• The formula doesn't consider how taking out money from earnings to pay the company's owner or give dividends to investors affects the ratio.
• These factors can give a wrong idea about the company's financial health if we only look at this ratio.
• Banks look at other benchmarks along with the fixed-charge coverage ratio to get a better understanding of the company's money situation when deciding to give a loan.

Different Types of Interest Coverage Ratios

EBITDA:

This ratio uses earnings before interest, taxes, depreciation, and amortization (EBITDA) instead of EBIT. With this method, you tend to get a higher ratio because it won’t include depreciation.

EBIAT: 

This ratio uses earnings before interest after taxes (EBIAT) instead of EBIT. It deducts the expenses of the tax to show a detailed picture of a company’s wealth to pay its interest.