Solvency Analysis: Fixed Charge Coverage Ratio

Can a Company Pay All Its Bills? Let's Find Out!

Introduction:

When we talk about a company's money, we want to know if it can pay for all the important things it needs to. Some of these important things are payments the company has to make regularly, like money it borrowed or needs to pay back. We call these fixed expenses. To understand if a company is doing well with its money, we use something called the Fixed Charge Coverage Ratio. It helps us see if the company can handle its fixed expenses and stay financially stable. This section will explain what the Fixed Charge Coverage Ratio is, how we calculate it, and why it's important.

Understanding the Fixed Charge Coverage Ratio:

The Fixed Charge Coverage Ratio helps us know if a company has enough money to pay its fixed expenses. Fixed expenses are like the bills a company must pay every month, like money it borrowed or needs to pay back. The ratio looks at both the money the company makes from its business and the money it needs to pay for these fixed expenses.

Fixed Charge Coverage Ratio = (Money the Company Makes + Fixed Expenses) / (Fixed Expenses + Interest Payments)

Interpretation of the Fixed Charge Coverage Ratio:

The Fixed Charge Coverage Ratio helps us understand if a company can handle its fixed expenses, including both the money it borrowed and needs to pay back. A higher Fixed Charge Coverage Ratio means the company is better at paying its bills and is in a stronger position. It shows that the company is not at much risk of having money problems. On the other hand, a lower Fixed Charge Coverage Ratio means the company might have trouble paying its bills and could be at higher risk.

Calculation of the Fixed Charge Coverage Ratio:

To calculate the Fixed Charge Coverage Ratio, we need to find two things: the top part (numerator) and the bottom part (denominator) of the ratio.

• Numerator: The top part of the ratio looks at the money the company makes from its business (we call it operating income) and the fixed expenses it has to pay. Operating income shows how much money the company earns from its business.
• Denominator: The bottom part of the ratio looks at the fixed expenses (like money borrowed and needs to pay back) and the interest payments the company has to make. Interest payments are the money the company pays for borrowing money.

Significance of the Fixed Charge Coverage Ratio:

The Fixed Charge Coverage Ratio is an important number that tells us if a company can pay its fixed expenses, including the money it borrowed and needs to pay back. It helps us see if the company is doing well financially, can handle its bills, and is not at much risk. We can also compare the company's Fixed Charge Coverage Ratio with other companies and how it performed in the past to understand its financial health and if it manages its bills well.

Example:

Let's imagine a company called XYZ and look at its numbers:

• Money the Company Makes: $500,000
• Fixed Expenses: $200,000
• Interest Payments: $100,000

Fixed Charge Coverage Ratio = ($500,000 + $200,000) / ($200,000 + $100,000)

Fixed Charge Coverage Ratio = $700,000 / $300,000

Fixed Charge Coverage Ratio = 2.33

In this example, Company XYZ has a Fixed Charge Coverage Ratio of 2.33. It means that the company's money from its business and fixed expenses can cover its bills and interest payments 2.33 times. A higher Fixed Charge Coverage Ratio shows that the company is good at paying its bills.

Conclusion:

The Fixed Charge Coverage Ratio helps us know if a company can pay its fixed expenses, like the money it borrowed and needs to pay back. It looks at how well the company manages its bills and stays financially stable. A higher Fixed Charge Coverage Ratio means the company is good at paying its bills and is not at much risk. By looking at this ratio, people who invest in companies or study them can make smart decisions about where to put their money.

This article takes inspiration from a lesson found in FIN 689 at Pace University.