Fixed charge coverage ratio (FCCR): the stricter cousin of DSCR

What FCCR measures

Every business has payments it cannot skip without damaging itself: the loan payments, the taxes, the equipment it must replace to keep operating. FCCR asks whether earnings cover all of them together, after the owners have taken their distributions. A ratio of 1 means the business exactly covered those charges with nothing left over; above 1, it had a cushion; below 1, it funded the gap from cash, the line of credit or new money.

The most common form in lower-middle-market credit agreements is:

FCCR = (EBITDA − unfinanced capital expenditures − cash taxes − distributions) ÷ (scheduled principal + cash interest)

Businesses with heavy leases, such as restaurants, retailers and some healthcare practices, are often measured on a lease-adjusted form instead, which adds rent back to EBITDA and adds rent to the fixed charges. That treats rent as the debt-like obligation it is, and makes a business that leases its buildings comparable to one that owns them with a mortgage.

How it differs from DSCR

The debt service coverage ratio and FCCR share a denominator in their simplest forms: principal and interest. The difference is in the numerator. DSCR often starts from EBITDA and stops there, or makes a few deductions. FCCR takes out the cash that leaves the business before a lender can be paid, whether the lender likes it or not.

Lenders use the two for different jobs. DSCR is the sizing question: how big a payment can this business carry? FCCR is the behavior question: after the owners run the business the way they intend to, including what they take out of it, is the lender still covered?

A worked example

A distribution business earns EBITDA of 2,000. It spends 300 on equipment and vehicles from its own cash, pays 150 in cash taxes, and distributes 250 to its owners. Its scheduled principal is 700 and its cash interest 340, for fixed charges of 1,040.

On EBITDA alone, the same business covers its debt service 1.92 times. On FCCR, it sits at 1.25x. Now suppose the owners take a larger distribution after a strong year, 500 instead of 250. FCCR drops to about 1.01: still above break-even, but the cushion is gone, and if the covenant is set above that level the business has tripped it without a single weak month in operations.

That is how FCCR covenants are often breached: not by a downturn, but by a distribution, a large equipment purchase paid from cash, or a tax payment that lands in the test period.

Where FCCR appears

Asset-based lines. An asset-based lender relies first on its borrowing base, so it usually does not want a battery of financial covenants. The typical ABL has one: a minimum FCCR that springs into effect only when excess availability falls below a set threshold. While the business keeps a cushion of unused availability, the covenant is not tested. When availability tightens, the lender wants to know the business is covering its fixed charges, and the test applies. See asset-based vs cash-flow lines.

Bank and private credit term loans. Many conventional term loans test FCCR quarterly on a trailing-twelve-month basis, often alongside a maximum leverage ratio. The FCCR covenant is what keeps distributions and capital spending from eroding coverage once the loan is out. See the covenants on a line of credit.

SBA loans rarely carry an FCCR covenant, but SBA lenders apply the same logic at underwriting when they deduct owner draws, taxes and the capital the business must keep spending.

The definitions worth negotiating

The ratio is only as fair as its definition. Before signing, read the credit agreement's definitions of EBITDA, capital expenditures, distributions and fixed charges, and look for:

• Unfinanced capital expenditures. Capex funded by an equipment loan should be excluded from the numerator; that loan's payments already appear in fixed charges. Make sure the definition says so.
• Tax distributions. Owners of pass-through entities pay the business's income tax personally. Agreements often treat distributions made to cover those taxes as taxes, not as discretionary distributions. Without that carve-out, the business is effectively penalized for its tax structure.
• Permitted add-backs. The agreement should list the add-backs credited at underwriting, such as one-time transaction costs, so the covenant is measured on the same earnings the loan was sized on. See EBITDA add-backs.
• The first test periods. After an acquisition or refinancing, the trailing twelve months include periods before the new debt existed. Agreements often annualize fixed charges for early quarters; check how.
• The springing trigger and cure. On an ABL, the availability level that triggers testing, and whether an equity contribution can cure a miss, matter as much as the ratio itself.

Managing to the covenant

Three habits keep an FCCR covenant from becoming a surprise. Compute the ratio monthly, on the agreement's definition, rather than discovering it in the compliance certificate. Time distributions and cash-funded capital spending with the test period in view, and finance larger equipment purchases instead of paying cash when the ratio is tight. And on an asset-based line, keep enough availability that the springing covenant never comes into force.

If a test is going to be missed, raising it with the lender before the certificate is due is almost always better than after. Lenders have options: a waiver, an amendment, an equity cure. They are more willing to use them for a borrower who saw it coming. See what to do when you breach a covenant.