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The Fixed Charge Coverage Ratio (FCCR) is a measure of how much cash flow there is to cover debt service payments.
If the ratio goes below 1.0, and absent additional financing, a business will go cash flow negative — no matter how profitable it may be.
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 fixed charges — the total of interest and principal payments. Sometimes, lease payments are also included in the denominator, particularly for businesses such as retailers with extensive leased real estate or lots of equipment financed with leases.
If you are a business owner, you want to keep an eye on this ratio;
a reduction is a warning that your company’s financial situation has deteriorated.
A Key Measure for Lenders
In almost all cases,
lenders include the FCCR as a positive covenant when lending money.
Why? Because it is a measure of a company’s ability to cover fixed charges or debt service. If the ratio goes below 1.0, the lender is financing a company that is bleeding cash.
The covenant is typically calculated on a trailing, 12-month basis. In other words, it is rear-view focused. It’s important to lenders because they want to act if a company’s financial situation changes in a way that the risk of default becomes higher than was bargained for when the money was loaned.
Small business lenders typically want a ratio higher than 1.2. Larger loans and investment-grade bonds often demand a much higher ratio. Asset-based loans — loans where recovery if the business heads south is only from liquidating receivables, inventory, and equipment — will go as low as 1.1 for banks and may not even be a covenant for a non-bank, asset-based lender.
But from a business owner’s perspective, higher is always better for actual performance,
particularly if the owner has personally guaranteed the loan.
Different Scenarios Dictate Different FCCR Requirements
A given company can borrow the same amount, but, with different types of loans, have different FCCR ratios.
How? By lowering the principal payments. This can be accomplished with interest-only payments or, if the lender insists on principal payments along the way, increasing the loan term (e.g., payments on a 30-year residential mortgage are lower than on a 15-year).
From a practical perspective, this can be done by financing current assets (think accounts receivables and inventory) with as much interest-only debt as you can arrange (e.g., revolvers and credit lines). Note that for these types of loans, payments that lower the loan balance from time to time are
not
included in the FCCR.
Finance fixed assets with a term as long as the expected life of that asset.
That said, lenders won’t finance 100% of your current assets and the term of your fixed debt will be shorter than the expected life of the assets the fixed term debt finances.
Recently,
I met with a company that was turned down for a credit line increase by its bank.
The credit line was a small fraction of the company’s accounts receivables, but the company was told its FCCR was too low (around 1.05). The company has two problems. First, it needs to improve profitability so there is more EBITDA to cover debt service. Second, its bank “termed” some of its debt.
That is, instead of a credit line that has interest-only payments, the loan is amortized like a residential mortgage over time with both principal and interest payments. The loan was amortized over only three years, effectively taking the company from zero principal payments to high principal payments (because of the short term). This company has the wrong lender and wrong debt structure.
A few more pointers…
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Finance current assets with a line of credit or revolver
(a loan amount based on how much of those assets you have). Those payments are interest only. Finance fixed assets with debt (even if camouflaged as a lease), with a term a bit shorter than the assets expected useful life.
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Negotiate pre/accelerated payment of term loans without penalty.
This allows you to prepay when cash flow is good, reducing future debt service costs.
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Project your financials and calculate the FCCR when you do.
You need to “see” what is in front of you so you can anticipate problems and take corrective action in advance. Lenders would much rather hear there might be a covenant problem
before
it happens; being blindsided by negative surprises always reduces the confidence others have in your business and your leadership of it.
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Make sure your lender is comfortable lending against your assets and capital needs.
Some lenders want the credit line to go to zero at some point during the year. If it doesn’t, they want to “term out your debt.” That’s a bad idea; look for a lender that won’t require this.
Final Thoughts
A business’s Fixed Charge Coverage Ratio is an important measure.
Use the concept to calculate the best capital structure for your business.
Then monitor this ratio to keep a close eye on its financial health.
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