The Fixed Charge Coverage Ratio (FCCR) in Credit Analysis: Cash Flow Confusion

Fixed Charge Coverage Ratio Definition: The Fixed Charge Coverage Ratio (FFCR) measures how easily a company can pay for the interest expense on its Debt, scheduled principal repayments, rent/lease payments, and other fixed expenses based on its available cash flow after most other recurring spending.

There are approximately 12,581,712 different definitions of the Fixed Charge Coverage Ratio (FCCR) floating around online, but the two most common seem to be the “Accounting” definition and the “Cash Flow” definition:

This “accounting” metric is inconsistent with the definition above because it does not consider scheduled Debt principal repayments in the denominator.

So, we prefer to use the “cash flow” definition shown below:

Some sources simplify this one and ignore the Rent/Lease Payments so that it’s more of a Debt Service ratio, but this defeats the point of the FCCR.

If you’re going to measure just Debt Service, use the Debt Service Coverage Ratio!

If the company has Preferred Stock, the Preferred Dividends should also be counted in the denominator as part of the “Fixed Charges.”

For some companies, you could arguably count Common Dividends as an ongoing cash outflow deducted in the numerator, reducing the available cash flow.

However, the basic principle is always the same: The numerator of this ratio should reflect the “available cash flow,” and the denominator should reflect the “fixed charges” the company must pay in each period, regardless of its revenue or overall business activity.

The FCCR should always be above 1.0x, indicating the company has enough cash flow to pay for its fixed charges, and the healthiest companies should see ratios of 2.0x, 3.0x, or even 4.0x or higher.

Files & Resources:

• Fixed Charge Coverage Ratio – Slides (PDF)
• Simple LBO Model – Fixed Charge Coverage Ratio Calculation (XL)

Video Table of Contents:

• 0:00: Introduction
• 0:37: The Short Version (OK, Not 3 Minutes)
• 6:28: Part 1: How to Interpret the FCCR in Real Life
• 9:45: Part 2: FCCR vs. DSCR vs. Leverage and Coverage Ratios
• 11:54: Part 3: What’s Wrong with the FCCR?
• 13:42: Recap and Summary

How to Interpret the Fixed Charge Coverage Ratio

The Fixed Charge Coverage Ratio is used with other credit metrics, such as the Leverage Ratio (Debt / EBITDA) and Interest Coverage Ratio (EBITDA / Interest), to determine a company’s credit risk, borrowing limits, and other terms when it issues Debt.

For example, a company projected to achieve an FCCR of 3 – 4x is more likely to get favorable terms on its Debt than a company with an FCCR of 1 – 2x.

That might translate into lower interest rates, fees, or more flexible repayment options.

The FCCR is also used as a covenant, or “requirement,” in many loan agreements.

For example, if a company issues a Term Loan, the lender might require the company to maintain a 1.5x minimum FCCR while the loan is outstanding.

If it does not, it might have to pay penalty fees or a higher interest rate. In extreme cases, the lender might even call for immediate repayment of the loan.

To illustrate, here’s a simple example of the FCCR calculation for Netflix in a credit model in the Base vs. Extreme Downside cases:

Based on the FFCR, Netflix is fine even if it delivers disastrous business results, such as a 5% annualized reduction in revenue in this Extreme Downside Case.

That’s because the company is not leveraged aggressively (only 2x Debt / EBITDA), it de-levers significantly over time, and it doesn’t have many “fixed charges,” with very low rent/lease payments and interest.

In fact, these results raise more questions about the calculation method than anything else.

Specifically, CapEx is not that meaningful for this type of company; it would be more accurate to count some of Netflix’s cash outflows on content licensing and development in the “Fixed Charges” calculation.

If we did that, the FCCR would fall to the ~1x level for Netflix in this Extreme Downside case, indicating likely credit problems.

We get a more questionable result for the fictional company used in the simple LBO model here:

This company’s FCCR ranges between 1.1x and 1.8x in this forecast period.

This is not a “red flag,” but would draw attention from the lenders.

The company is leveraged quite aggressively – 5x Debt / EBITDA on an 8x EBITDA acquisition – and its cash flows are weaker in the early years as it transitions to a “capital-light” business model.

Lenders might dig into a result like this, stress-test the model in different scenarios, and evaluate the FCCR if the company’s business model transition takes longer than expected or its margins stagnate or decline.

The Fixed Charge Coverage Ratio lets the lenders quantify the risk and determine the higher interest rate or fees they might charge to compensate.

Fixed Charge Coverage Ratio vs. Debt Service Coverage Ratio

The Debt Service Coverage Ratio and Fixed Charge Coverage Ratio are similar in some ways, but their calculations and usage differ.

Both include the Interest Expense + Scheduled Debt Principal Repayments in the denominator, and the numerator for both metrics measures the “cash flow available” to make these payments.

The DSCR numerator is the Cash Flow Available for Debt Service, while it’s a more loosely defined “available cash flow” or “modified EBITDA” for the FCCR.

The key differences are:

• Usage: The DSCR is more of a Project Finance metric used for individual assets, such as solar plants or toll roads, and its definition is straightforward and widely agreed-upon. Also, in addition to credit analysis, the DSCR is used to size and sculpt Debt.
• Rent/Lease Payments: The DSCR does not measure the asset’s ability to pay for these since it relates strictly to the Debt. The CFADS in the numerator deducts these expenses, but the denominator of the DSCR does not count them at all.
• CapEx: The numerator of the FCCR deducts all CapEx – both Growth and Maintenance – while the CFADS in the numerator of the DSCR deducts only Maintenance CapEx.
• Working Capital: This is a minor point, but CFADS normally includes the Change in Working Capital, so it affects the DSCR; most FCCR calculations do not account for Working Capital.

You could calculate the Debt Service Coverage Ratio for corporations rather than infrastructure assets, but typically it is based on something like:

Corporate DSCR = (Free Cash Flow + Interest/Rent/Other Fixed Charges) / (Interest/Rent/Other Fixed Charges + Scheduled Debt Principal Repayments)

Using Free Cash Flow rather than starting with EBITDA and deducting CapEx and Cash Taxes means a wider variety of line items go into the calculation.

This may be what you want, but be careful because this “Corporate DSCR” is very similar to the FCCR in most cases:

The fact that it’s so different from the FCCR in this Netflix example says more about the possible shortcomings of the FCCR than anything else.

Fixed Charge Coverage Ratio vs. Interest Coverage Ratio and Leverage Ratio

The Leverage Ratio and Interest Coverage Ratio are much simpler metrics that are defined as Total Debt / EBITDA and EBITDA / Interest, respectively.

There are variations, such as ratios where you use Net Debt or the Net Interest Expense, and others where you subtract CapEx, the Change in Working Capital, or Cash Taxes from EBITDA, but the fundamentals are simple.

Lenders look at all these metrics when stress-testing a company and considering new deals, and they have the same basic trade-offs as Free Cash Flow vs. EBITDA.

One set of metrics is simpler to calculate and better for comparisons (EBITDA, Debt / EBITDA, and EBITDA / Interest), while the other set is more difficult to calculate, closer to the actual cash flows, but less useful for comparing different companies (Free Cash Flow and the Fixed Charge Coverage Ratio).

You can see examples of these ratios for Netflix below:

What’s Wrong with the Fixed Charge Coverage Ratio?

The Fixed Charge Coverage Ratio should be an improvement over the Leverage Ratio and Interest Coverage Ratio because it uses something closer to the company’s true cash flow to measure its ability to service Debt and pay for rent…

…but it’s not quite that simple in real life.

First, there are dozens of different definitions for the FCCR.

The line items included in “Fixed Charges” are not strictly defined, and for some companies, such as Netflix above, CapEx is less meaningful than spending on intellectual property and content.

“Fixed Charges” does not include variable expenses, such as COGS for a manufacturing company, but within the SG&A or R&D categories on a company’s Income Statement, you could make cases for and against many different line items.

IFRS 16 and lease accounting create further complexities.

For any IFRS-based company, EBITDA already excludes the full lease expense, so you do not add it back in the “available cash flow” numerator of the FCCR.

But you still add it in the denominator since it still represents a required cash outflow.

If the company follows U.S. GAAP, you do add the Operating Lease Expense, normally listed as “Rent” on the Income Statement, in the numerator of the FCCR.

Under U.S. GAAP, the Operating Lease Expense is a simple deduction on the Income Statement that directly reduces EBITDA, so you must add it back to determine the “available cash flow.”

Finally, there are issues around Common Dividends and Distributions and whether they should be deducted to calculate a company’s “available cash flow.”

In some industries, like equity REITs, companies must issue certain percentages of Dividends to maintain their corporate/tax/legal status, so there is a case for doing this.

But in other industries, such as utilities or midstream/MLP companies in oil & gas, there’s no “requirement” to issue a certain amount of Dividends.

Companies in both industries have historically cut or raised Dividends when required, so it’s more difficult to argue they are true fixed charges.

For all these reasons, the Fixed Charge Coverage Ratio works well in theory but sometimes struggles to perform in real life.