Definition of Asset Coverage Ratio
Asset coverage ratio measures the ability of a company to cover its debt obligations with its assets. The ratio tells how much of the assets of a company will be required to cover its outstanding debts. The asset coverage ratio gives a snapshot of the financial position of a company by measuring its tangible and monetary assets against its financial obligations. This ratio allows the investors to reasonably predict the future earnings of the company and to asses the risk of insolvency.
Usually a minimum level of asset coverage ratio is defined in the covenants so that a company does not overextend its debts beyond a certain limit. The company would not be tempted to take too much loans; therefore chances of its insolvency are less. As a rule of thumb, industrial and publicly held companies should maintain an asset coverage ratio of 2 and utilities companies should maintain an asset coverage ratio of 1.5.
Asset Coverage Ratio Usage
The asset coverage ratio is a popular financial solvency ratio used by lenders. It measures how well a company can cover its short-term debt obligations with its assets. A company that has more assets than it does short-term debt and liability obligations indicates to the lender that the company has a better chance of paying back the funds it lends in the event they cannot be covered by company earnings. The higher the asset coverage ratio, the more times a company can cover its debt. Therefore, a company with a high asset coverage ratio is considered to be less risky than a company with a low asset coverage ratio.
Calculation (formula) of Asset Coverage Ratio
The asset coverage ratio is calculated in three steps:
- Step 1: The current liabilities are added up and short term debt obligations are subtracted from this sum.
- Step 2: The book value of tangible and monetary assets of a company is calculated by subtracting the value of intangible assets (such as goodwill) from the book value of total assets. The figure calculated in Step 1 is subtracted from this figure.
- Step 3: The resulting figure of Step 2 is divided by the total outstanding debt of the company.
All of these three steps can be expressed in the following formula for asset coverage ratio.
Asset Coverage Ratio = ((Total Assets – Intangible Assets) – (Current Liabilities – Short-term Debt)) / Total Debt Obligations
In this equation, “assets” refers to total assets, and “intangible assets” are assets that can’t be physically touched, such as goodwill or patents. “Current liabilities” are liabilities due within one year, and “short-term debt” is debt that is also due within one year. “Total debt” includes both short-term and long-term debt. All of these line items can be found in the annual report.
There is one caveat to consider when interpreting this ratio. Assets found on the balance sheet are held at their book value, which is often higher than the liquidation or selling value in the event a company would need to sell assets to repay debts. The coverage ratio may be slightly inflated. This concern can be partially eliminated by comparing the ratio against other companies in the same industry.
Norms and Limits for Asset Coverage Ratio
Asset coverage ratio should be used in conjunction with other financial ratios to have clearer picture of the company’s financial strengths and weaknesses. A negative point of asset coverage ratio is that it uses the book value of the assets. The book value may vary significantly from the actual liquidation value of the asset. In such a case the asset coverage ratio will give misleading results.
Generally, asset coverage of over 1x is considered as a good sign; however, it will vary from industry to industry. For example, in utility companies a ratio of 1.0-1.5x is considered healthy while for capital goods companies a ratio of 1.5-2.0x is a norm.
Asset Coverage Ratio Analysis
If a company’s earnings fall short of covering its company’s financial liabilities, the business may have to generate cash by selling some of its assets. The asset coverage ratio shows how many times the company can pay its debts through its assets in case its earnings become insufficient.
However, there are a few flaws of the asset coverage ratio that must be considered by anyone who uses it. One is the fact that the ratio is based on a company’s ‘book value’. This means the ratio could be higher than it actually appears and may offer an unrealistically optimistic picture of the company and its capacity to settle its obligations.
According to analysts, this can be remedied by valuing assets at their actual depreciated value, which easily provides a more realistic reflection of the company’s ability to cover its debt through its assets.
Another way to prevent skewed results is to compare the company’s ratio with the ratios of other companies that are in the same industry. This makes the result more reliable as it is based on a more comprehensive body of data. Like other financial metrics, the asset coverage ratio is not helpful enough and may even provide a false picture when used standalone.
Also, this ratio will likely be more informative and useful to businesses when used with many other performance and coverage ratios to provide a more solid and accurate view of the company and its debt-paying abilities. Helpful as it is, the asset coverage ratio cannot offer helpful insight into a company’s true financial state unless taken during several periods, again for comparison purposes.
Asset Coverage Ratio Conclusion
- The asset coverage ratio shows how capable a company is of paying its debt through its assets.
- This formula requires five variables: total assets, intangible assets, current liabilities, short-term debt, and total debt.
- The asset coverage ratio is expressed as a number.
- A higher asset coverage ratio indicates a greater ability to settle a debt.
- High asset coverage ratio is considered to be less risky.