Fixed Charge Coverage
The term fixed charge coverage refers to a metric that allows the investor-analyst to understand the ability of a company to meet its fixed cost commitments. A company's fixed charge coverage evaluates its fixed expenses versus its cash flow.
Fixed Charge Coverage = Fixed Costs / Cash Flow from Operations
- Fixed costs are equal to the sum of the company's fixed expenses and fixed costs. This includes all non-variable costs as well as commitments such as lease payments, long-term rents and principal payments on loans. Fixed costs can also be found by taking sales revenues and subtracting all short run variable cost including sales commissions and direct materials. Generally, dividend payments are not considered a fixed cost.
- Cash flow from operations is found by taking net income, adding non-cash expenses, and subtracting out non-cash sales.
Cash flow measures allow the investor-analyst to understand if the company is generating enough cash flow from ongoing operations to keep the company in a financially sound position over the long term. One of the ways to measure the ability of the company to generate enough cash from its core business operations is by calculating its fixed charge coverage ratio.
Fixed charge coverage is a ratio than enables the investor-analyst to understand how much of the cash flow a company generates is required to pay its fixed costs. This is an important metric because if a company's sales declines, it still needs to be able to pay its fixed costs. This metric evaluates performance in terms of fixed costs keeping in mind that even what appears to be a fixed cost can be a variable one over the long term.
For this reason, the fixed cost coverage ratio should be higher than one. How much higher will depend on the industry, so this metric is a good one to benchmark performance.
Company ABC's Board of Directors believes it may be better to split the company's electric distribution business from its generating business. To gain additional insights into the performance of each business, the company's CFO asks an analyst to determine the cash flow return on revenue for each business as shown below:
The above table reveals that both lines of business at Company ABC are producing reasonable levels of cash flow and each is worth keeping; the distribution business slightly outperforming its generating business.