To calculate the fixed charge coverage ratio, add fixed charges before tax to earnings before interest and taxes, then divide that sum by fixed charges before tax plus interest. The standard equation is:
FCCR = (EBIT + Fixed Charges Before Tax) ÷ (Fixed Charges Before Tax + Interest)
A result of 1.5 means the business earns $1.50 for every dollar of mandatory payments it owes. Most lenders want to see at least 1.25 before approving a loan, and a figure below 1.0 signals the company can’t cover its obligations from operations alone.
What Goes Into Each Part of the Formula
EBIT is the profit a business generates from its core operations before paying lenders or the government. Fixed charges before tax include lease and rent payments. Interest covers all borrowing costs on loans, bonds, and credit lines.
The numerator adds lease payments back to EBIT because the income statement already subtracted them, and the calculation needs to reflect the full pool of cash available to meet obligations. The denominator captures everything the company is contractually locked into paying.
For companies with preferred stock outstanding, preferred dividends work as another fixed charge. They’re contractual payments that must be made before common shareholders see anything. Add the preferred dividend amount to both the numerator and the denominator alongside lease payments.
Where to Find the Numbers
Three figures drive the standard calculation, and each sits in a slightly different place.
- EBIT (operating income). Near the bottom of the income statement, usually labeled “operating income” or “income from operations.” This is profit from running the business, before interest and taxes.
- Interest expense. Listed as a non-operating expense on the income statement, or broken out in the financial statement footnotes when the debt structure is complex.
- Lease and rent payments. Under current U.S. accounting rules (ASC 842), operating lease costs appear as a single expense line within operating income, typically grouped into cost of sales or general and administrative expenses. The dollar amount often requires a look at the supplemental notes in a 10-K or annual report, where companies disclose total operating lease expense.
Getting the lease number right matters more than people expect. Pull the wrong line or miss a category of lease, and the entire ratio shifts. Companies with heavy equipment leases, retail locations, or fleet vehicles tend to have obligations scattered across multiple footnotes, so read carefully.
A Worked Example
Suppose a small manufacturer reports the following annual figures:
- EBIT: $500,000
- Interest expense: $80,000
- Annual lease payments: $120,000
Build the numerator by adding lease payments back to EBIT: $500,000 + $120,000 = $620,000.
Build the denominator by adding lease payments and interest: $120,000 + $80,000 = $200,000.
Divide: $620,000 ÷ $200,000 = 3.1.
An FCCR of 3.1 means this manufacturer earns more than three dollars for every dollar of fixed obligations. That’s a comfortable cushion. A lender reviewing this company would see low risk of missed payments even if revenue dropped significantly.
Adding Principal Payments and the Tax Adjustment
The standard formula captures interest and leases, but many lenders want a fuller picture that includes scheduled debt principal repayments. The current portion of long-term debt, which is the principal amount due within the next twelve months, sits on the balance sheet under current liabilities. Including it in the denominator makes the ratio more conservative and more realistic, because principal payments represent real cash leaving the business.
The wrinkle is that principal payments come from after-tax dollars. A company doesn’t get a tax deduction for repaying loan principal the way it does for interest. To account for this, gross up the principal payment to its pre-tax equivalent:
Tax-Adjusted Principal = Principal Payment ÷ (1 − Tax Rate)
At the current 21% federal corporate tax rate, a $100,000 principal payment actually requires about $126,582 in pre-tax earnings ($100,000 ÷ 0.79).
Return to the manufacturer and assume $60,000 in annual principal payments. The tax-adjusted principal is $60,000 ÷ (1 − 0.21) = $75,949. The expanded denominator becomes $80,000 (interest) + $120,000 (leases) + $75,949 (tax-adjusted principal) = $275,949. Dividing the $620,000 numerator by $275,949 gives an adjusted FCCR of 2.25, down from 3.1 under the standard formula. A business that looks very comfortable under the basic calculation can look noticeably tighter once principal repayments enter the picture.
The EBITDA Variation
Some lenders and analysts prefer a more cash-flow-oriented version of the ratio that starts with EBITDA instead of EBIT. EBITDA adds depreciation and amortization back to operating income, since those are non-cash accounting entries rather than actual money going out the door. The depreciation and amortization figure appears on the cash flow statement or in the financial statement notes.
The trade-off is that EBITDA overstates available cash if the company needs to spend money maintaining its equipment and facilities. A conservative approach subtracts maintenance capital expenditures from EBITDA in the numerator, along with cash taxes paid. Growth-related capital spending is typically excluded from this adjustment because it’s discretionary. The resulting formula:
FCCR = (EBITDA − Maintenance CapEx − Cash Taxes) ÷ (Interest + Lease Payments + Tax-Adjusted Principal)
This is the strictest common formulation. It tells you whether the company can cover all its fixed obligations after accounting for the minimum spending needed to keep the business running. Expect a lower number than either the standard EBIT-based or basic EBITDA-based calculation produces.
Reading the Result
A ratio of 1.0 means the company earns exactly enough to cover its fixed charges with nothing left over. There’s no margin for a slow quarter, an unexpected repair, or a customer who pays late. Anything below 1.0 means the business is already falling short and must tap cash reserves, sell assets, or take on additional debt just to stay current. Lenders treat sub-1.0 numbers as a flashing red light.
Most commercial lenders set a floor around 1.25, which provides a 25% buffer above break-even. For every dollar of fixed charges, the business earns $1.25. That cushion absorbs normal fluctuations in revenue and costs without threatening payment schedules. Higher ratios generally translate to better borrowing terms and lower interest rates, since the lender faces less risk.
The ratio is also worth tracking over multiple quarters or years. A declining trend, even from a healthy starting point, can signal trouble before any single reading crosses a threshold. If a covenant tests quarterly, running the calculation monthly gives you time to react before the number becomes someone else’s problem.