Understanding Fixed Charge Coverage Tests

Fixed charge coverage ratio (FCCR) covenants are the early warning system that 45% of leveraged borrowers are currently failing. When FCCR drops below 1.25x, covenant breach probability jumps dramatically, credit spreads widen by 25-50 basis points, and suddenly that high-yield bond you thought was stable faces accelerated repayment risk. The durable lesson: FCCR isn't an academic ratio buried in footnotes. It's the metric that separates performing credits from workouts.

What FCCR Actually Measures (And Why Interest Coverage Falls Short)

The fixed charge coverage ratio answers a specific question: can this company pay all its non-negotiable obligations from operating cash flow? Unlike the simpler interest coverage ratio (EBITDA / Interest), FCCR captures the full burden of fixed obligations.

The calculation structure:

Numerator: Adjusted EBITDA minus cash taxes minus unfunded capital expenditures Denominator: Interest expense plus mandatory debt amortization plus lease payments

A worked example with real numbers:

You're analyzing a mid-market industrial company with:

• EBITDA: $48 million
• Cash taxes paid: $6 million
• Maintenance CapEx: $8 million
• Cash interest expense: $14 million
• Scheduled principal payments: $10 million
• Lease payments: $4 million

FCCR = ($48M - $6M - $8M) / ($14M + $10M + $4M) FCCR = $34M / $28M = 1.21x

The point is: this company covers its fixed charges, but barely. One quarter of weak EBITDA and it breaches. Compare this to a simple interest coverage of 3.4x ($48M / $14M) (which looks healthy) and you see why FCCR matters more.

FCCR Thresholds (What the Numbers Signal)

Different lender types set different minimums, and the thresholds signal credit quality directly:

Typical covenant minimums by lender type:

• Small business/ABL lenders: 1.20x minimum
• Middle-market leveraged loans: 1.10x to 1.25x
• Investment-grade credits: 2.0x or higher typical
• Strong/acquisition financing: 1.25x to 1.50x with step-ups

What the ratio signals about credit risk:

The practical point: when analyzing credit spreads, FCCR below 1.25x should command a meaningful premium. Research from Lincoln International shows average FCCR across leveraged borrowers dropped to 1.26x in Q1 2023 (down from 1.40x in Q1 2022). Forward-looking calculations with sustained higher rates pushed this to 1.04x (Chen and Miller, 2023), meaning roughly half these borrowers couldn't cover fixed charges.

Springing Covenants (The Hidden Trigger)

Most leveraged credit agreements don't test FCCR continuously. Instead, they use a springing covenant: the FCCR test activates only when liquidity falls below a threshold (typically the greater of $10 million or 10% of the borrowing base).

Why this matters for bondholders:

A company can have terrible FCCR for quarters without triggering a breach, as long as it maintains adequate revolver availability. The moment working capital needs spike (seasonal inventory build, receivables delays, CapEx timing), availability drops, the covenant springs, and the company discovers it's been in violation territory all along.

The detection signal: Watch for companies with:

• Revolver utilization above 70%
• FCCR below 1.30x on trailing twelve months
• Seasonal working capital swings exceeding 15% of the borrowing base

This combination creates breach risk even when current financials look acceptable.

A Real Breach Scenario (Phase-by-Phase)

Your situation: You hold $500,000 in bonds from a mid-market plastics manufacturer yielding 8.5% (SOFR + 400 bps). The company has operated comfortably with FCCR around 1.45x for years.

Phase 1: The External Shock (Q3)

Hurricane activity disrupts Gulf Coast resin supply. Input costs spike 35% over two months. EBITDA drops from a run-rate of $52 million to $38 million annualized. Fixed charges remain constant at $32 million.

New FCCR: $38M / $32M = 1.19x

The company draws on its revolver to fund working capital, pushing utilization to 78% (above the 75% springing threshold). The FCCR covenant activates.

Phase 2: Technical Default (Q4)

Quarterly compliance certificate shows FCCR at 1.19x against a covenant minimum of 1.25x. The company is in technical default despite making every interest and principal payment on schedule.

The lender's options now include:

• Accelerating the entire loan balance
• Increasing the interest rate by 200-400 bps (default rate)
• Requiring additional collateral
• Restricting further revolver draws
• Demanding immediate refinancing

Phase 3: The Workout

Management requests a covenant waiver. The lender grants a six-month covenant holiday but extracts:

• Fee of 75 bps on outstanding balance
• Interest rate increase of 100 bps
• New minimum liquidity covenant of $15 million
• Monthly (not quarterly) financial reporting
• Prohibition on dividends and acquisitions

Your bond position: The market prices in distress. Bonds trade from par to $92 (an 8% loss). Yield widens to 10.2%. If the company stabilizes, you eventually recover. If costs remain elevated or demand weakens, the next step is restructuring.

The durable lesson: technical default on FCCR creates real economic damage even when cash flows technically cover debt service. The lender's remedies destroy value for all stakeholders below the secured debt.

Reading FCCR in Credit Agreements (Where Retail Investors Go Wrong)

The specific definition of FCCR varies by agreement. Reading the credit agreement (typically filed as an exhibit to the 10-K or 8-K) reveals crucial details:

Common definitional traps:

1. Adjusted EBITDA add-backs: Some agreements allow adding back restructuring charges, one-time costs, or even projected synergies. This inflates the numerator artificially. Check for language like "pro forma effect" or "permitted adjustments."

2. Funded vs. unfunded CapEx: Agreements that exclude "funded" CapEx (financed with additional debt) from the numerator but include the debt service in the denominator can create circular problems.

3. Lease treatment under ASC 842: Post-2019, operating leases appear on-balance-sheet. Some agreements use the pre-adoption treatment (leases in denominator only). Others double-count by including depreciation of right-of-use assets in EBITDA and lease payments in fixed charges.

4. Trailing vs. forward-looking: Most covenants test trailing twelve-month FCCR, but some test quarterly or require minimum projected coverage for the next twelve months.

Where to find the definition:

SEC filings location: 10-K Exhibit 10.x (Credit Agreement) Section: "Definitions" subsection or "Financial Covenants" article

Search for: "Fixed Charge Coverage Ratio" or "Consolidated Fixed Charges"

FCCR and Pricing Grids (The Spread Connection)

Many credit facilities include a margin ratchet or pricing grid that adjusts interest rates based on leverage or coverage metrics. While most grids key off Debt/EBITDA, some include FCCR thresholds.

Example pricing grid structure:

The point is: even above the covenant minimum, declining FCCR increases borrowing costs. A company that drops from 2.1x to 1.6x (both technically "passing") sees borrowing costs rise by 50 bps (annualized interest expense increase of roughly $1 million per $200 million of floating-rate debt).

For bondholders: secondary spreads should reflect this same relationship. A bond trading at +350 bps with FCCR of 1.35x offers less cushion than the same spread at 1.85x.

Covenant-Lite and Why FCCR Matters More Now

The covenant-lite trend has profound implications for FCCR monitoring. PitchBook LCD data shows covenant-lite loans represented 89% of outstanding US leveraged loans and 93% of new issuance in 2023.

What this means practically:

In a covenant-lite structure, there's no FCCR maintenance test. The company can operate with coverage below 1.0x indefinitely, as long as it makes scheduled payments. The covenant only triggers on an incurrence (taking on new debt, making an acquisition, paying a dividend).

The paradox for investors: You get fewer early warnings, but when problems emerge, they're more severe. By the time a covenant-lite borrower trips an incurrence test, liquidity is often exhausted.

Detection signals in covenant-lite credits:

• Monitor quarterly FCCR even without a maintenance test
• Watch for amendments requesting covenant relief (signals management sees problems ahead)
• Track revolver availability trends
• Compare FCCR to secured leverage for relative priority analysis

Mitigation Checklist (Tiered by Impact)

Essential (Prevents 80% of Surprises)

These checks should be standard for any leveraged credit exposure:

• Calculate FCCR yourself using disclosed financial data (don't rely on management's adjusted version)
• Read the covenant definition in the credit agreement, specifically EBITDA add-backs and fixed charge components
• Note the springing threshold (availability level that activates the test)
• Track trailing twelve-month FCCR quarterly; flag any reading below 1.40x

High-Impact (For Active Credit Monitoring)

For portfolios with significant high-yield or leveraged loan exposure:

• Build a forward-looking FCCR model using consensus EBITDA estimates and known debt service
• Set alerts for revolver utilization disclosures (8-K filings, earnings calls)
• Monitor peer FCCR trends; sector-wide deterioration signals macro stress
• Track covenant amendment filings; waiver requests often precede formal breach

Advanced (For Concentrated Positions)

If a single issuer represents more than 5% of your fixed-income allocation:

• Request or download the full credit agreement (not just the summary term sheet)
• Model stress scenarios: what EBITDA decline triggers breach?
• Calculate the "covenant cushion" (current FCCR minus minimum as percentage)
• Assess lender composition; bank groups with relationship lending may grant more flexibility than CLO managers

Detection Signals (How You Know FCCR Risk Is Building)

You're likely exposed to FCCR deterioration if:

• Your high-yield holdings have average leverage above 5.0x Debt/EBITDA
• You own bonds from issuers with more than 40% of EBITDA going to interest expense
• The issuer has had a covenant amendment in the past 18 months
• Management discusses "tight liquidity" or "managing working capital closely" on calls
• The bond has widened more than 100 bps without obvious news

The test: Can you calculate the issuer's FCCR from their latest 10-Q without using management's adjusted numbers? If not, you're flying blind on covenant risk.

Next Step (Put This Into Practice)

Pull the most recent 10-K for your largest high-yield or leveraged loan holding. Calculate FCCR using the numbers below:

Your calculation:

1. Find EBITDA (or calculate: Operating Income + D&A)
2. Find cash taxes paid (Cash Flow Statement)
3. Find maintenance CapEx (or use total if not disclosed separately)
4. Find interest paid (Cash Flow Statement)
5. Find current portion of long-term debt (Balance Sheet)
6. Find lease payments (Note disclosure or Cash Flow Statement)

FCCR = (EBITDA - Cash Taxes - CapEx) / (Interest + Principal + Leases)

Interpretation:

• Above 1.5x: Adequate cushion for most scenarios
• 1.25x to 1.5x: Monitor quarterly; one weak quarter creates risk
• Below 1.25x: Active distress risk; investigate covenant terms immediately

Action: If FCCR is below 1.40x and you can't articulate why this issuer will improve, reduce the position or demand wider spread compensation.

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References:

Lincoln International. (2023). Leading Indicators Show Risk for Potential Loan Payment Defaults. Lincoln International LLC.

Fukui, T. (2024). Fixed Cost Coverage Ratio: Operating Leverage, Risk, and Cost of Capital. SSRN Working Paper.

Paul Weiss. (2023). Covenant-Lite Loans: Overview. PitchBook LCD Data.

Deloitte. (2024). Credit-Related Covenant Violations That Cause Debt to Become Repayable. DART Codification.