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Fixed Charges

A type of business expense that occurs on a regular basis

What are Fixed Charges?

Fixed charges are a type of business expense that occurs on a regular basis, and is independent of the volume of business. Fixed charge is an umbrella term for a variety of expenses, including principal and interest payments for a loan, insurance, taxes, utilities, salaries, and rent and lease payments.

 

Fixed Charges

 

There are certain expenses that are fixed by agreements, such as pension fund contributions, which are also included under fixed charges. Lenders often look at fixed expenses to determine the debtor’s ability to repay a loan.

 

Summary:

  • Fixed charges are a type of business expense that occurs on a regular basis, and is independent of the volume of business.
  • Fixed charge is an umbrella term for a variety of expenses, including principal and interest payments for a loan, insurance, taxes, utilities, salaries, and rent and lease payments.
  • Fixed expenses are different from variable expenses as the latter is dependent on the volume of business. A fixed expense is dependent on the production capacity of the company and not its real level of output, while variable costs are directly proportional to the volume of sales.

 

Fixed vs Variable Costs

Fixed costs are different from variable expenses as the latter is dependent on the volume of business. A fixed expense is dependent on the production capacity of the company and not its real level of output, while variable costs are directly proportional to the volume of sales.

For example, the income of a salesperson may be determined by the volume of products sold by the company or by that particular salesperson. Although independent of the volume of business, fixed costs disproportionately impact a company’s bottom line based on the number of variations of products offered by the company.

 

Floating Charge

There are certain assets involved in the ordinary course of business that may be considered dynamic. It refers to a variance in the availability of goods transacted on a daily basis. A floating charge is created on such assets that grant the creditors ownership of whatever goods are left upon completion of the company’s normal business transactions.

The creation of the floating charge is done is to ease restrictions on the income-generating activities of the company. The assets in question are not fixed, and neither are their respective ownership rights. For example, if a building is used to secure a loan, a fixed charge is created for the creditor. However, if the stock part of the inventory of a storehouse is used as collateral, a floating charge is created for the creditor.

 

Fixed Charge Coverage Ratio

The Fixed Charge Coverage Ratio (FCCR) predicts the repayment capacity of a borrower by using earnings before interest and taxes (EBIT) and dividing this amount by the total fixed charges of the company. Another variant for the same is when earnings before interest, taxes, depreciation, and amortization (EBITDA) is the numerator, and the fixed charge is the denominator.

For example, an FCCR of 1.5 means that for every $1 of debt incurred, the company holds $1.50 of income at its disposal. FCCR reflects the cash flow at the disposal of the company for the purpose of debt repayment. Clearly, the higher the FCCR, the lower the burden of a fixed charge and the better.

If the current volume of business is insufficient to cover the fixed assets, the business will find trouble with the creditors who hold the collateral. It is because a decline in earnings can be detrimental for the company and create panic among its investors. Banks, analysts, and corporate finance accountants often consider FCCR while evaluating the repayment capacity of potential borrowers.

 

Related Readings

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Analysis of Financial Statements
  • Cost of Goods Manufactured (COGM)
  • FCCR Template
  • Step Costs

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