Adjusted fixed charge

What Is Adjusted Fixed Charge?

Adjusted fixed charge refers to the total of a company's financial obligations that are relatively constant, regardless of its operational output or sales volume. These charges are typically included when calculating a company's ability to meet its recurring financial commitments and are a key component in various financial ratios used in corporate finance. Examples of adjusted fixed charges commonly include interest expense on debt, scheduled principal repayments, and significant lease payments. Analyzing adjusted fixed charge is critical for assessing a company's creditworthiness and overall financial health.

History and Origin

The concept of accounting for fixed charges has evolved alongside modern financial reporting and lending practices. Historically, debt agreements and other financial instruments always required companies to demonstrate their ability to meet recurring obligations. As business structures became more complex and leasing became a prevalent financing method, the scope of what constituted a "fixed charge" expanded.

A significant development impacting the definition of adjusted fixed charge, particularly concerning leases, was the introduction of new accounting standards like IFRS 16 (International Financial Reporting Standard 16) and ASC 842 (Accounting Standards Codification 842) by the IASB and FASB, respectively. Effective January 1, 2019, IFRS 16, for instance, mandated that most leases be recognized on a company's balance sheet as a "right-of-use" asset and a corresponding lease liability. This change eliminated the previous "off-balance sheet" treatment of operating leases, leading to a reclassification of lease expenses. Prior to IFRS 16, operating lease payments were often treated as operating expenses on the income statement. Post-IFRS 16, these are typically split into depreciation expense (for the right-of-use asset) and interest expense (for the lease liability), thereby directly impacting how a company's fixed charges are perceived and calculated for financial ratios like the fixed charge coverage ratio. PwC's analysis highlights that this new standard significantly affects various commonly used financial ratios and performance metrics, including interest cover and operating cash flows.⁷

Key Takeaways

• Adjusted fixed charge represents a company's mandatory and recurring financial obligations, such as interest, principal payments, and lease expenses.
• It is a crucial input for assessing a company's ability to service its debt and other fixed commitments.
• The inclusion of various recurring payments beyond just interest highlights a comprehensive view of financial burden.
• Changes in accounting standards, like IFRS 16, have significantly altered how lease payments are treated, directly impacting the calculation of adjusted fixed charges.
• Lenders and analysts use adjusted fixed charge to evaluate a company's financial stability and default risk.

Formula and Calculation

The specific components of an adjusted fixed charge can vary depending on the context (e.g., loan covenants, industry practices). However, a common comprehensive approach includes interest expense, lease payments, and scheduled principal repayments on debt.

The calculation of the total adjusted fixed charge can be represented as:

• Interest Expense: The cost of borrowing money.
• Lease Payments: Regular payments for the use of an asset under a lease agreement. This now often includes both the interest and principal portions of lease liabilities under modern accounting standards.
• Scheduled Principal Repayments: The portion of debt repayments that are due within a specific period, as per the loan's amortization schedule. This excludes balloon payments or unscheduled repayments.

For example, when calculating the fixed charge coverage ratio, this adjusted fixed charge amount forms the denominator, indicating the total fixed obligations a company must cover from its earnings.

Interpreting the Adjusted Fixed Charge

A company's adjusted fixed charge is interpreted in relation to its earnings or cash flow to determine its capacity to meet these obligations. A higher adjusted fixed charge, relative to a company's earnings, indicates a greater financial burden and potentially higher risk. Lenders and investors closely examine this figure, often in the context of coverage ratios, to gauge how much cushion a company has after covering its core fixed costs.

For instance, if a company's earnings before interest and taxes (earnings before interest and taxes (EBIT)) are barely above its adjusted fixed charge, it suggests a precarious financial position where even a slight downturn in revenue could lead to difficulties in meeting its payments. Conversely, a robust level of earnings significantly exceeding the adjusted fixed charge indicates strong financial stability and a greater capacity to handle unforeseen financial pressures or pursue growth opportunities.

Hypothetical Example

Consider "Tech Solutions Inc.," a software company that recently expanded and took on additional debt and leased new office spaces and equipment. For the past fiscal year, Tech Solutions Inc. reported the following:

• Interest Expense: $1,000,000
• Lease Payments (total, as per new accounting standards): $800,000
• Scheduled Principal Repayments on Debt: $1,200,000

To calculate the adjusted fixed charge for Tech Solutions Inc.:

Adjusted Fixed Charge = $1,000,000 (Interest Expense) + $800,000 (Lease Payments) + $1,200,000 (Scheduled Principal Repayments)
Adjusted Fixed Charge = $3,000,000

If Tech Solutions Inc. had earnings before interest, taxes, depreciation, and amortization (EBITDA) of $6,000,000, this adjusted fixed charge of $3,000,000 would be used to assess its ability to cover these fixed costs, highlighting a 2x coverage ratio. This calculation helps stakeholders understand the direct financial commitment the company faces each period, providing a clear picture of its recurring obligations.

Practical Applications

Adjusted fixed charge is a fundamental component in assessing a company's ability to manage its financial commitments and is widely used across several areas:

• Debt Covenants: In loan agreements, lenders often include debt covenants that require borrowers to maintain a certain fixed charge coverage ratio, where the adjusted fixed charge is the denominator. Failing to meet these covenants can trigger an event of default, leading to higher interest rates, accelerated repayment schedules, or other penalties.⁶
• Credit Analysis: Credit rating agencies and financial analysts use adjusted fixed charge to evaluate a company's creditworthiness. A lower adjusted fixed charge relative to a company's earnings generally indicates a stronger ability to repay debt, which can lead to better credit ratings and lower borrowing costs.
• Investment Decisions: Investors analyze adjusted fixed charge as part of their due diligence to understand a company's financial stability. Companies with manageable adjusted fixed charges are often viewed as less risky investments, particularly for bondholders seeking predictable returns.
• Corporate Strategy: Management teams consider adjusted fixed charge when making strategic decisions, such as taking on new debt, entering into large lease agreements, or planning capital expenditures. Understanding the impact of new fixed obligations on coverage ratios is crucial for maintaining financial flexibility. For example, TotalEnergies, despite a drop in profit and rising debt, committed to maintaining shareholder buybacks, indicating a strategic assessment of their adjusted fixed charges against their cash flow capacity.⁵

Limitations and Criticisms

While valuable, relying solely on adjusted fixed charge or related coverage ratios has its limitations:

• Definition Variability: The specific definition of "fixed charges" can vary significantly across industries, companies, and even individual loan agreements. What one entity includes (e.g., capital expenditures, taxes, preferred dividends) another might exclude, making direct comparisons challenging without careful scrutiny of the underlying definitions.⁴
• Accounting Standard Changes: As seen with IFRS 16, changes in accounting standards can alter how certain items, like lease payments, are classified and measured, thereby affecting the calculated adjusted fixed charge and associated ratios. While these changes aim to improve transparency, they can complicate historical comparisons.³
• Backward-Looking Nature: Financial ratios are typically based on historical financial data. They may not accurately predict a company's future ability to meet its adjusted fixed charge obligations, especially in rapidly changing economic environments or during periods of significant company transformation.
• Does Not Account for Volatility: The adjusted fixed charge itself is a static sum for a period, not reflecting the volatility of the earnings stream that is supposed to cover it. A company with highly volatile earnings might have a seemingly healthy coverage ratio in one period but struggle in another.
• Context is Key: A high adjusted fixed charge can be sustainable for a company in a stable, high-margin industry, but problematic for one in a cyclical or low-margin business. The acceptable level of adjusted fixed charge must be evaluated within the specific industry and economic context. Research suggests that while debt covenants are often used to manage risk, their effectiveness and the consequences of their violation can vary, highlighting the complexity of financial distress.²

Adjusted Fixed Charge vs. Fixed Charge Coverage Ratio

Adjusted fixed charge and the Fixed Charge Coverage Ratio (FCCR) are closely related but represent different concepts.

Adjusted Fixed Charge is the sum of a company's recurring financial obligations that are relatively constant, such as interest expense, lease payments, and scheduled principal repayments. It is an absolute dollar amount representing the total burden of these fixed commitments.

The Fixed Charge Coverage Ratio (FCCR), on the other hand, is a ratio that measures a company's ability to cover its adjusted fixed charges with its available earnings, usually earnings before interest and taxes (EBIT) plus fixed charges before tax, divided by total fixed charges.¹ The FCCR provides a solvency metric, indicating how many times a company's earnings can cover its fixed obligations. A higher FCCR suggests greater financial stability, while a ratio below 1.0 indicates that the company's earnings are insufficient to meet its fixed obligations.

The confusion between the two often arises because the "adjusted fixed charge" is the key component (the denominator, and part of the numerator's adjustment) in calculating the Fixed Charge Coverage Ratio. One is the sum of the obligations, the other is the measure of how well those obligations are covered.

FAQs

What is typically included in an adjusted fixed charge?

An adjusted fixed charge commonly includes interest expense, lease payments (both operating and finance leases under modern accounting standards), and scheduled principal repayments on debt. Some definitions may also include preferred dividends, capital expenditures, or cash taxes.

Why is adjusted fixed charge important for lenders?

Lenders use adjusted fixed charge to assess a borrower's capacity to repay debt. By comparing it to a company's earnings, they can determine the risk of default. If the adjusted fixed charge is high relative to earnings, it signals a higher risk. This is often codified in debt covenants within loan agreements.

How have accounting changes impacted adjusted fixed charge?

Recent accounting changes, particularly IFRS 16, have significantly impacted the calculation of adjusted fixed charge. These standards require most leases to be recognized on the balance sheet, reclassifying previous operating lease expenses. This change often increases the reported adjusted fixed charge for companies that previously had substantial off-balance sheet operating leases.

What is a good adjusted fixed charge amount?

There isn't a single "good" adjusted fixed charge amount in absolute terms, as it depends on the size and industry of the company. Instead, it's the relationship between the adjusted fixed charge and a company's earnings (often expressed as a Fixed Charge Coverage Ratio) that indicates its financial health. A ratio greater than 1.0 is generally considered necessary, with higher ratios indicating a stronger ability to cover obligations.