Difference Between Fixed Charge Coverage Ratio and Debt Service Coverage Ratio

Fixed charge coverage ratio and debt service coverage ratio are important indicators of the gearing level (proportion of debt in the capital structure) in a firm.  The key difference between fixed charge coverage ratio and debt service coverage ratio is that fixed charge coverage ratio assesses the ability of a company to pay off outstanding fixed charges including interest and lease expenses whereas debt service coverage ratio measures the amount of cash available to meet the debt obligations of the company. It is vital to distinguish between these two ratios properly since these two can be confusing since they convey somewhat similar meanings.

CONTENTS
1. Overview and Key Difference
2. What is Fixed Charge Coverage Ratio
3. What is Debt Service Coverage Ratio
4. Side by Side Comparison – Fixed Charge Coverage Ratio vs Debt Service Coverage Ratio
5. Summary

What is Fixed Charge Coverage Ratio?

The fixed charge coverage ratio (FCCR) measures a company’s ability to settle fixed charges, such as interest and lease expense. These charges will be reflected in the income statement after the operating profit. The following formula is used to calculate FCCR.

Fixed Charge Coverage Ratio = (EBIT + Fixed Charge Before Tax)/ (Fixed Charge Before Tax + Interest)

FCCR looks at the firm’s ability to cover its fixed charges from the profits earned. This is very similar to interest coverage ratio which calculates the ability to settle interest payments. For instance, if the calculated interest coverage is 4, this means that the company is able to pay interest 4 times from the earnings made. FCCR differs from interest coverage ratio since it consider additional fixed charges such as lease expenses and insurance expenses in addition to interest.

E.g. ABC Ltd.’s EBIT for the last financial year is $420,000. The company incurred an interest expense of $38,000 and other fixed charges of $ 56,000 before tax.

FCCR = ($420,000+56,000)/ (56,000+38,000) = 5 times

ABC can use its earnings to pay off fixed charges up to 5 times, which is a favorable coverage ratio. A lower ratio will indicate that the company finds it difficult to pay off its fixed charges.

What is Debt Service Coverage Ratio?

Also known as debt coverage ratio, debt service coverage ratio (DSCR) measures how much funds are available to meet the debt obligations of the company. This includes funds available to settle interest, principal and lease payments. DSCR is calculated as per below.

Debt Service Coverage Ratio = Net Operating Income / Total Debt Service

E.g. BCV Ltd earned a net operating income of $475,500 for the year ended 31.12.2016. BCV’s total debt service is $400,150. The resulting DSCR is 1.9 ($475,000/$400,150)

Since DSCR is more than 1, this indicates that the company is well equipped with profits to cover debt payments. If DSCR is less than 1, this will indicate that the company has not generated sufficient income to cover the debt obligations. This ratio particularly becomes important when the company wants to obtain a loan since banks may require the ratio to be at an agreed level.

There is no specified ideal ratio for debt service coverage that companies have to achieve. However, since DSCR is a vital ratio considered by banks prior to granting loans, the type and amount of the loan and the nature of the relationship the company has with the bank will contribute to deciding the ideal ratio.

What is the difference between Fixed Charge Coverage Ratio and Debt Service Coverage Ratio?

Summary- Fixed Charge Coverage Ratio vs Debt Service Coverage Ratio

The main difference between fixed charge coverage ratio and debt service coverage ratio depends on whether they are focused on calculating the ability of the company to settle fixed charges or to calculate the funds available to meet the debt obligations. Both these ratios provide an indication of the level of gearing in the company; thus, they can be considered as vital ratios. If these ratios are lower than an acceptable level, additional sources of finance will have to be considered.

References
1.”Fixed-Charge Coverage Ratio.” Investopedia. N.p., 13 Feb. 2015. Web. 30 Mar. 2017.
2. Wood, Meredith. “How to Calculate Your Fixed Charge Coverage Ratio (and Why It’s Important).” Fundera Ledger. Fundera, 08 Feb. 2017. Web. 30 Mar. 2017.
3. “Debt-Service Coverage Ratio (DSCR).” Investopedia. N.p., 24 Nov. 2015. Web. 30 Mar. 2017.
4. Schmidt, Robert. “How to Calculate The Debt Service Coverage Ratio (DSCR).” PropertyMetrics. N.p., 17 Feb. 2016. Web. 30 Mar. 2017.

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