The Fixed Charge Coverage Ratio (FCCR) is a common covenant in loan and bond agreements and a crucial measure for businesses to project.
In short, it’s a measure of how much cash flow there is to cover fixed charges. If the ratio goes below 1, a business will go cash flow negative, absent additional financing, no matter how profitable it is.
Typically, the FCCR is calculated as Earnings Before Interest and Taxes, plus Depreciation and Amortization (EBITDA), less cash paid for non-financed capital expenditures, less cash distributed to owners for taxes (for LLCs and S-Corps), all divided by the total of interest and principal payments. Sometimes, lenders require the inclusion of lease payments in the denominator, particularly for businesses such as retailers with extensive leased real estate or lots of equipment financed with leases.
While I discussed the FCCR in this newsletter
just last year,
with all the uncertainty facing businesses in today’s pandemic, the FCCR is even more critical.
Why? Several reasons.
For many businesses, EBITDA is lower and very uncertain. Meanwhile, debt levels have often increased. And while there have been temporary deferrals and reductions in fixed charges, such as loan payments and rents, the amount owed has increased as a result. As for those with PPP loans, for the amount that is not forgiven, businesses will have to agree with their lender on repayment terms, leading to additional fixed charges.
“Look Ahead” Projections Are Critical
I have mentioned the need to do “look ahead” projections many times (
here
and
here
). The FCCR should be calculated as part of these. The key is to look out 12 to 24 months with a focus on the balance sheet and cash flow. Keep the projections high level and avoid getting bogged down with specific account items.
Consider many scenarios. At the moment, we are in a
world of uncertainty instead of risk. What will happen in the near future cannot be predicted with the same degree of confidence as in normal times. So, understand the implications of all scenarios — and look at the FCCR for each.
Most businesses should project at least two FCCRs. One that follows the definition in loan and bond agreements (note that businesses with more than one loan may have more than one FCCR definition) and one that is for internal use and is more encompassing. For the latter, make sure to include
all fixed leases, whether real estate, capital equipment leases, and equipment rentals that have a minimum fixed term, such as truck leases. Why the more stringent FCCR? Because that is reality, regardless of what your loan and bond agreements may require.
Now, what to do about the projected FCCR once calculated?
First, check under which scenarios your business will default its loan covenants. Loan modifications (or more) may be needed. Second, work to change the FCCR.
How to Change an FCCR for the Better
Obviously, increase the numerator, decrease the denominator, or some combination of both.
When increasing the numerator, don’t kid yourself by increasing revenue. That is what different scenarios are for. Rather, revisit costs. By definition, a dollar out the door can’t be recovered. So, cut costs sooner rather than later, paying special attention to those costs that can be restored quickly if conditions improve. For some businesses this is head count; for others, services, etc.
Also,
look at delaying or reducing capital expenditures. Capacity improvements with falling or uncertain demand are pretty obvious. But, when cutting expenses or CAPEX, be careful not to undermine the business’s competitive position. Also, be careful postponing capital expenditures if the result will be increased downtime or higher labor expense. Use common sense and standard capital project review measures.
Now for the harder part: Decreasing the denominator, the total of all fixed charges.
Leases. When do they expire? For example, when I was in food service distribution, we had a large fleet of trucks, all financed in a series of staggered, five-year operating leases. The trucks usually lasted about seven years, so at the end of the lease term, we could buy the equipment, or return the equipment and not lease replacements if we were going to have too many. After that, comes negotiations with the lessors, some of which will be more agreeable than others.
Financing agreements. Remember, credit lines are typically interest only, so the FCCR impact is minimal. If your FCCR is too tight, find ways to increase the credit line. How large is the credit line compared to easily liquidated accounts receivable and inventory? Sometimes, going from a traditional loan to an asset-based loan will allow for a larger credit line.
Look for additional collateral. Perhaps there are foreign accounts receivable that traditional lenders don’t like as collateral, but specialty lenders and factors might lend against. In some industries, there are special lenders that will take a second position on current assets or will increase the credit line with other collateral such as patents, trademarks and so forth. Credit risk can be reduced with credit insurance, that might allow a lender to increase a credit line.
For example,
I obtained a new financing package for a client in the aggregates business. The owner had a small credit line that was maxed out and a small term loan from a conventional bank. The owner had stumbled a few times and was struggling to repay vendors. The solution was a new financing package from a non-bank, asset-based lender. It provided a very large credit line that was interest only and two modest term loans of five and fifteen years. The lender’s comfort came from its familiarity with the industry and knowing that most of the accounts receivables were backed by either surety bonds or statutory mechanic liens and that the inventory could be liquidated easily for close to cost.
Amortization period of term loans. Can term loans be refinanced in whole or in part with funds from an increased credit line? Look at extending the amortization period of the loan. Is the term loan cash flow-based or collateral-based? If the FCCR is still tight and the loan is a cash flow loan, these lenders may want to be replaced with a collateral-based lender. Look at extending the amortization period and/or the term of the loan to reduce fixed charges. Again, look for more collateral.
Asset disposition. The proceeds of these can be used to pay down term loans, thereby reducing fixed charges. This may include unused equipment, product lines, locations and more.
Equity. By increasing equity, loans can be paid off, thereby reducing the FCCR. New equity can be raised to pay down debt or, sometimes, lenders will be willing to convert debt to equity, particularly if they lack other viable ways to get paid.
Restructuring. This gets complicated. Sometimes, it may be necessary to
force some creditors to reduce their fixed charges. In the case of converting debt to equity, it may be a condition of the conversion. For example, many years ago I helped a movie theatre chain restructure in bankruptcy. The company was stuck with many leases on outdated facilities. A bond holder agreed to convert notes to equity and new equity came in as well. The price? A bankruptcy that flushed out all old equity, got out of the bad leases and only paid unsecured creditors a bit more than 10 cents on the dollar. The denominator got zapped!
Get Help. Most businesses don’t restructure fixed charges frequently. So, get help from those that do so on a routine basis. That includes tax expertise, too.
Final Thoughts
Staying cash flow positive is essential for the viability of every business.
In today’s uncertain world, the FCCR is an especially critical measure for monitoring today’s reality and being prepared for an unknowable future.
