How does debt service coverage ratio differ from fixed charge coverage ratio?

How does debt service coverage ratio differ from fixed charge coverage ratio?

• A. Debt service coverage uses net income after taxes; fixed charge coverage uses net income before taxes.
• B. Debt service coverage uses gross profit; fixed charge uses net income after taxes.
• C. Debt service coverage uses operating cash flow; fixed charge uses net income after taxes.
• D. Debt service coverage uses asset turnover; fixed charge uses debt ratio.

Answer: (A)

Debt service coverage and fixed charge coverage look at different sources of income to judge ability to meet obligations. The debt service ratio is tied to the cash actually available after taxes, so it uses net income after taxes as the base. Taxes reduce cash flow, and debt payments come out of that after-tax cash, so this ratio reflects the real cushion you have to make debt payments. The fixed charge coverage ratio, by contrast, focuses on fixed obligations like debt service and lease payments, which don’t vary with taxes. To assess whether there’s enough earnings to cover those fixed costs, the ratio uses earnings before those taxes (pretax earnings) as the base. Taxes shouldn’t distort whether fixed charges can be met, so pretax earnings provide a clearer measure. So, debt service coverage uses after-tax income, while fixed charge coverage uses pre-tax income.

Debt service coverage and fixed charge coverage look at different sources of income to judge ability to meet obligations. The debt service ratio is tied to the cash actually available after taxes, so it uses net income after taxes as the base. Taxes reduce cash flow, and debt payments come out of that after-tax cash, so this ratio reflects the real cushion you have to make debt payments.

The fixed charge coverage ratio, by contrast, focuses on fixed obligations like debt service and lease payments, which don’t vary with taxes. To assess whether there’s enough earnings to cover those fixed costs, the ratio uses earnings before those taxes (pretax earnings) as the base. Taxes shouldn’t distort whether fixed charges can be met, so pretax earnings provide a clearer measure.

So, debt service coverage uses after-tax income, while fixed charge coverage uses pre-tax income.