On October 31, 2018, Sterling Construction Company entered into a credit agreement with Comerica Bank. The following appeared among the agreement's financial covenants: "Commencing with the fiscal quarter ending December 31, 2018, maintain as of the end of each fiscal quarter a Fixed Charge Coverage Ratio of not less than 1.25 to 1.00." The credit agreement also contained a "definitions" section where this item was listed: " 'Fixed Charge Coverage Ratio' shall mean as of any date of determination a ratio the numerator of which is EBITDA for the Applicable Measuring Period, minus cash taxes and cash tax distributions with respect to such period and the denominator of which is the sum of Current Maturities of Long Term Debt plus interest paid during the trailing twelve month period, plus

Question

twenty-five percent (25%) of the daily average total non-amortizing debt during the trailing twelve month period."Required:a. What is a minimum fixed charge coverage ratio and what purpose does it serve in the company's loan agreements?b. Why is it necessary for the loan agreement to precisely define "Fixed Charge Coverage Ratio?"

What will be an ideal response?

Answer 1

a. 
The Fixed Charge Coverage Ratio is a ratio that indicates a firm's ability to satisfy fixed financing expenses or other fixed charges. Creditors desire such provisions in loan covenants because their interests are protected when the borrower maintains this ratio above some acceptable minimum level.

b. 
A quick Google search for the term turned up the definitions below, neither of which is the same as the one appearing in the Sterling credit agreement or the TCBY example illustrated in the text. Thus, to avoid misunderstandings or violation of (intended) covenant terms, it is important to carefully define all ratios and other financial measures used in loan agreements that may be subject to interpretation, etc. 

The Fixed Charge Coverage Ratio is "the ratio of (Earnings before interest, depreciation and amortization minus unfunded capital expenditures and distributions) divided by total debt service (annual principal and interest payments). Notice that lease payments are sometimes included in the calculations." 

The Fixed Charge Coverage Ratio is "the ratio of (net earnings before taxes plus interest charges paid plus long-term lease payments) to (interest charges paid plus long-term lease payments)."