Are you looking to secure a loan, but need help determining which metrics lenders and investors will use to assess your eligibility? FCCR vs. DSCR are two financial ratios used by lenders and investors. Understanding the differences between them can help you position yourself better for approval. This article will cover the FCCR and DSCR and how they affect your chances of getting a loan.
Fixed Charge Coverage Ratio (FCCR)
The fixed charge coverage ratio evaluates a firm or company’s ability to cover its fixed charges with earnings in a given period. In other words, the FCCR measures how well a company’s earnings can be used to pay off its fixed charges such as rent, interest expenses, debt payments, and lease expenses.
This ratio shows how often earnings are covered before interest expenses and taxes. For example, a company with fixed costs of $15 million and earnings before interest and tax of $45 million would have its fixed charge covered three times. This ratio is one way of analyzing a firm’s vulnerability to fluctuations in profit and interest rates.
Lenders and investors use this metric to determine whether or not they can give a loan or invest in a company because it shows how likely they are to have a loan repaid. Firms, investors, or companies with high FCCR, usually have less of their profits flowing into fixed charges, which means they have sufficient cash flow to make timely payments easier. Meanwhile, it is the reverse for firms with low FCCR.
The Fixed Charge Coverage Ratio Formula (FCCR)
Fixed charge coverage ratio = (EBITDA + Fixed charges before Taxes) / (Fixed charges before Taxes + Interest expenses)
*EBITDA – Earnings before Interest, taxes, depreciation, & amortization
Example of the Fixed charge coverage ratio
Let us say a company records EBITDA of $400,000, lease payments and rent of $200,000, and $100,000 in interest payments. Calculate FCCR.
Step 1:
Using the formula, we will calculate the numerator by adding the EBITDA to the fixed charges, which are the lease payment and rent, i.e., $400,000 + $200,000 = $600,000
Step 2:
We will now calculate the denominator by adding the fixed charges to interest expense, i.e., $200,000 + $100,000 = $300,000
Step 3:
Lastly, we divide the numerator by the denominator to get the fixed charge coverage ratio, i.e., $600,000/ $300,000 = 2
Therefore, the company’s earnings are two times greater than its fixed charges. The value is considered low because the company could only pay its fixed charges twice with its earnings, therefore increasing the risk that it cannot make future payments. The higher the fixed charge coverage ratio value, the better.
Limitations of Fixed Charge Coverage Ratio
One of the main concerns of this metric is that it is not the best indicator of the future performance of a company or property because it is based on historical information.
Also, the FCCR does not consider spontaneous changes in the amount of capital for companies. The effects of dividends paid to investors are also not considered.
Hence, in evaluating a company’s creditworthiness for a loan, other indicators, including the fixed charge coverage ratio, are used to gain more insight into a company’s financial position.
Debt Service Coverage Ratio (DSCR)
The debt service coverage ratio is a yardstick that measures the rate at which a company’s cash flow can pay off its current debt obligations. It is a credit metric that measures the ability of a firm to cover its loans. DSCR compares a firm’s total debt obligations, including capital expenditures and principal repayments, to its operating income.
The DSCR is an important financial metric that helps lenders determine the creditworthiness of a company or borrower. As an investor, your DSCR might differ from the standard figure you need to collect a loan. In such a scenario, the DSCR mortgage program enables you to secure your loan based on the rental income forecasts your property will bring, rather than the income standards that most mortgage lenders use.
The Debt Service Coverage Ratio Formula
DSCR = Net Operating income(NOI) / Current debt obligations
Where:
Net operating income = Revenue – Certain Operating Expenses(COE)
As a borrower, it is necessary to know that lenders might calculate DSCR slightly differently.
Example of the Debt Service Coverage Ratio in use
Let’s say a company discloses to a bank that it has a net operating income of $300,000 per year and has to pay yearly interest of $60,000 on that loan. Therefore, the lender will calculate the DSCR to ascertain whether or not this company is credit-worthy.
Solution
Using the given formula,
i.e., $300,000/ $60,000
DSCR = 5
A DSCR of 5 indicates the company has five times enough cash flow to cover its debt obligation.
Limitations of the Debt Service Coverage Ratio
One of the problems of the Debt Service Coverage Ratio is that the net operating income only includes some expenses, which can lead to the overstatement of a company’s financial potential.
FCCR vs. DSCR: Comparison
FCCR vs. DSCR: indicators of a company’s liquidity position and gearing level.
The difference between the FCCR and the DSCR is that the FCCR evaluates a company’s potential to cover its fixed charges with its earnings. In contrast, DSCR assesses the rate at which a company’s cash flow can pay off its debt obligation.
The DSCR is computed using the net operating income, i.e., Revenue – Certain Operating Expenses (COE). In contrast, the FCCR is computed using the EBITDA, i.e., Expenses before Interest, Taxes, Depreciation, and Amortization.
Also, the DSCR does not consider certain obligations or expenses that a company needs to operate, for example, rent.
Final Words
DSCR vs. FCCR: both are used similarly by lenders and analysts to understand the financial health of an individual, firm or operating company. Theoretically, both metrics have similar meanings and measure a company’s ability to generate enough profit to run its operations and pay off its debt and obligations. Learning the pros and cons of DSCR loans and how they work can be crucial.
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