Description: A company may have such a high level of fixed costs that it cannot survive a sudden downturn in sales. The fixed charge coverage ratio can be used to see if this is the case. It summarizes a company’s fixed commitments, such as principal payments, long-term rent payments, and lease payments, and divides them by the total cash flow from operations. A ratio close to one reveals that a company must use nearly all of its cash flows to cover fixed costs, and is a strong indicator of future problems if sales drop to any extent. A company in this position can also be expected to drop prices in order to retain business, since it cannot afford to lose any sales.
Formula: Summarize all fixed expenses, leases, and principal payments for the year, and divide them by the cash flow from operations. It is generally not necessary to include dividend payments in this calculation, since this should not be considered fixed over the long term. The types of expenses and other payments that are fixed can be subject to some interpretation; for example, if a lease is close to expiring, there is no need to include it in the formula, since it is a forward looking measure, and there will be no lease payments in the future. Also, if a company is expecting to reduce its principal payments by extending a loan over a longer time period, this may also be grounds for reducing the amount of fixed payment listed in the ratio. The formula is as follows:
Fixed Expenses + Fixed Payments
Cash Flow from Operations
Cautions: The simple compilation of fixed charges is not sufficient when calculating the fixed charge coverage ratio; some charges may be included or excluded, depending upon the uses to which the ratio is to be put. Also, an increasing number of costs may be considered fixed in the short term, while nearly all costs can be considered variable if a sufficiently long time-frame is used. For example, if fixed costs are considered to be any costs that cannot be eliminated by management within the next month, then this must also include any purchase orders that will not be completed during that period, as well as any contract that will not expire during that period. On the other hand, if the period is extended out to more than a year, it is possible that even some loan payments can be successfully accelerated and completed during the intervening period, thereby eliminating them from the fixed charge list. Consequently, the time period during which costs are to be considered fixed charges has a large bearing on the outcome of the ratio.