What does the earnings to fixed charges ratio measure?

QUESTION

What does the earnings to fixed charges ratio measure? What does this ratio add to the other tools of credit analysis?
Answer: The ratio of earnings to fixed charges is a measure of a companys ability to cover fixed costs with the earnings of the current period. A high ratio indicates that earnings are sufficiently covering fixed expenses of the company. Fixed charge coverage ratio is the most meaningful ratio out of all the coverage ratios from a general point of view. It is basically a ratio of earnings to total fixed liabilities. As it covers all the fixed liabilities, its coverage is wider compared to other ratio such as debt service coverage ratio, dividend coverage ratio, interest service coverage ratio etc.. Fixed charges are those charges in any business which occur irrespective of the level of production and the revenues. They are fixed by their nature and do not change with a marginal increase in the activity of the business. The fixed charges include the interest charge, lease payments, preference dividend, instalments of a loan, etc. The ratio is very simple to interpret; a high ratio denotes good performance by the company. Lower

ratios are not appreciated for the financial health of a business. Lower ratios mean that the company is not able to cover its fixed charges and that the company is not able to generate enough revenues to pay its liabilities thus there is a risk of bankruptcy. Credit analysis helps find out if the company will be able to pay off its debts in time. As tool for credit analysis, fixed charges coverage ratio helps to find out about the financial health of the company. a company with a ratio less than 1 would mean that it is not able to pay its debts or fixed charges and is bound to fail. Credit rating agencies use this ratio to rate the company for the purpose of bond rating, General rating etc

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