The fixed charge coverage ratio is the earnings before interest and taxes plus any lease expenses, which is then divided by the sum of the interest expenses and lease expenses, according to AccountingTools. A fixed charge coverage ratio indicates how much of a company's revenue goes toward expenses rather than profits.
For example, Acme Brick had $500,000 in earnings before interest and taxes last year. Leases amounted to $100,000, and there was $50,000 in interest expenses. The fixed charge coverage ratio is $500,000 plus $100,000, divided by $100,000 plus $50,000. Simplified, the ratio is $600,000 divided by $150,000, or 4-to-1. Companies often omit any expenses about to expire for a reporting period, notes AccountingTools.
If this ratio is too low, any sudden drop in a company's profits may make the firm financially insolvent because too much revenue goes to pay fixed expenses such as a building lease, interest expenses for loans and leases for a fleet of vehicles. The fixed charged coverage ratio delineates the financial strength of a company in terms of prospective borrowers that may lend money to the firm, explains AccountingTools. When a business incurs too many fixed expenses versus cash flow, revenue and profit cannot be reinvested in the company to make more profit. The sooner interest payments and leases are paid, the better the fixed charge coverage ratio.