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Fixed-Charges Coverage Ratio in QuickBooks 2012

The fixed-charges coverage ratio is one of several leverage ratios can be used in QuickBooks 2012. The fixed-charges coverage ratio resembles the times interest earned ratio. The fixed-charges coverage ratio calculates how easily a firm pays not only its interest expenses but also any principal payments on loans and any other obligations for which a firm is legally obligated to pay.

The fixed-charges coverage ratio uses the following formula:

income available for fixed charges/fixed charges

Check out the balance sheet shown and the income statement shown.

A Simple Balance Sheet
Assets
Cash $25,000
Inventory 25,000
Current assets $50,000
Fixed assets (net) 270,000
Total assets $320,000
Liabilities
Accounts payable $20,000
Loan payable 100,000
Owner’s equity
S. Nelson, capital 200,000
Total liabilities and owner’s equity $320,000
A Simple Income Statement
Sales revenue $150,000
Less: Cost of goods sold 30,000
Gross margin $120,000
Rent 5,000
Wages 50,000
Supplies 5,000
Total operating expenses 60,000
Operating income 60,000
Interest expense (10,000)
Net income $50,000

Suppose that the $5,000 of rent shown in the income statement is actually a fixed charge because the firm is renting space on a long-term lease. Further suppose that, for the purpose of this ratio, although it doesn’t show up on the income statement, the $100,000 loan that shows up on the balance sheet requires annual $5,000 in principal payments.

In this case, this firm is obligated to pay fixed charges as summarized. In total, then, fixed charges for this firm equal $20,000 a year.

Fixed Charges Calculation
Interest $10,000
Rent 5,000
Principal 5,000
Fixed charges $20,000

The other input needed to calculate the fixed-charges coverage ratio is the income available for these fixed charges. The following shows you how to calculate the income available for fixed charges.

Income Available for Fixed Charges
Operating income $60,000
Add back of rent 5,000
Fixed charges $65,000

You start with the operating income, which equals $60,000. (Remember that the operating income is the income before paying interest expense.) You must add to the operating income any fixed charges included in the income statement.

In this case, the rent turns out to be a fixed charge. Therefore, the $5,000 of rent needs to be added to the operating income in order to get income available for fixed charges. The income available for fixed charges equals $65,000.

With the two needed inputs, you can calculate the fixed-charges coverage ratio by using this formula:

$65,000/$20,000

This formula returns a fixed-charges coverage ratio of 3.25, which indicates that the firm generates slightly more than three times as much income as needed to pay its fixed charges.

No guideline exists to specify what your fixed-charges coverage ratio should be. In fact, it is particularly difficult to get the information necessary to think about fixed-charge coverage ratios because fixed charges don’t clearly appear in the standard set of simple financial statements.

One of the things that make financial statements (that are prepared in accordance with generally accepted accounting principles) so useful is that the fixed-charges information is usually disclosed in little footnotes that appear at the end of the financial statements.

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