Asset Coverage Ratio

What is the 'Asset Coverage Ratio'

The asset coverage ratio is a test that determines a company's ability to cover debt obligations with its assets after all liabilities have been satisfied. When calculating the asset coverage ratio, investors should exercise caution with respect to asset value; using the coverage ratio of the actual liquidation value of assets is significantly less. As a rule of thumb, utilities should have an asset coverage ratio of at least 1.5, and industrial companies should have an asset coverage ratio of at least 2.

BREAKING DOWN 'Asset Coverage Ratio'

Companies have two primary ways to raise capital: through debt and through equity. Equity does not need to be paid back if earnings fall, but debt must be paid back no matter what. As a result, banks and investors holding debt want to know that company's earnings are sufficient to cover future debt obligations, but they also want to know what happens if earnings falter. One option, just as it is for the average person, is to start selling assets. The asset coverage ratio tells bankers and investors how many times the company's assets can cover its debts.

Asset Coverage Ratio Usage

If a company wants a loan, it goes to its banker first. The banker then analyzes the company's balance sheet to see if it can afford the loan. In particular, and especially if the company has a poor credit rating, the bank is likely to require the company to provide collateral in the form of assets that can be sold if the company defaults on the loan.

One popular financial solvency ratio is the asset coverage ratio. It measures how well a company can cover its short-term debt obligations with assets. A company that can cover its debts with assets which is to say, the company that has more assets than it does short-term debt, is the better company. The more times it can cover this debt, the better. So, a company with a high asset coverage ratio is considered to be less risky than a company with a low asset coverage ratio, even if it has poor credit history and/or a history of default.

Asset Coverage Ratio Calculation

The asset coverage ratio is calculated with the following equation:

((Assets – Intangible Assets) – (Current Liabilities – Short-term Debt)) / Total Debt

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 and debts 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. The coverage ratio may be slightly inflated. This concern can be partially eliminated by comparing the ratio against other companies in the same industry.

RELATED TERMS
  1. Interest Coverage Ratio

    A debt ratio and profitability ratio used to determine how easily ...
  2. Coverage Ratio

    A measure of a company's ability to meet its financial obligations. ...
  3. Long Term Debt To Total Assets ...

    A measurement representing the percentage of a corporation's ...
  4. Debt Ratio

    A financial ratio that measures the extent of a company’s or ...
  5. Current Ratio

    The current ratio is a liquidity ratio measuring a company's ...
  6. Liquidity Ratios

    A class of financial metrics that is used to determine a company's ...
Related Articles
  1. Investing

    How to Calculate a Coverage Ratio

    In broad terms, the higher the coverage ratio, the better the ability of the enterprise to fulfill its obligations to its lenders.
  2. Investing

    An Introduction To Coverage Ratios

    Interest coverage ratios help determine a company's ability to pay down its debt.
  3. Investing

    Calculating Long-Term Debt to Total Assets Ratio

    A company’s long-term debt to total assets ratio shows the percentage of its assets that are financed with long-term debt.
  4. Investing

    Understanding Leverage Ratios

    Large amounts of debt can cause businesses to become less competitive and, in some cases, lead to default. To lower their risk, investors use a variety of leverage ratios - including the debt, ...
  5. Investing

    Total Debt to Total Assets

    Total Debt to total assets, also called the debt ratio, is an accounting measurement that shows how much of a company’s assets are funded by borrowing. In business, borrowing is also called leverage.
  6. Investing

    Debt Ratio

    The debt ratio divides a company’s total debt by its total assets to tell us how highly leveraged a company is—in other words, how much of its assets are financed by debt. The debt component ...
  7. Investing

    Financial Analysis: Solvency Vs. Liquidity Ratios

    Solvency and liquidity are equally important for a company's financial health. A number of financial ratios are used to measure a company’s liquidity and solvency, and an investor should use ...
  8. Investing

    Analyzing Wal-Mart's Debt Ratios in 2016 (WMT)

    Analyze Wal-Mart's debt-to-equity ratio, interest coverage ratio and cash flow-to-debt ratio to evaluate the company's financial health and debt management.
  9. Markets

    Do Your Investments Have Short-Term Health?

    If a company is strong enough to survive tough times, it is more likely to provide long-term value.
  10. Investing

    Analyzing General Electric's Debt Ratios in 2016 (GE)

    Evaluate GE's debt picture using the most important metrics for a large-cap conglomerate, including the debt-to-equity (D/E) ratio and the interest coverage ratio.
RELATED FAQS
  1. Which types of coverage ratios should I look at when deciding to invest in a company?

    Find out why coverage ratios are useful for investors to know and which three coverage ratios an investor should understand ... Read Answer >>
  2. If a company has a high debt to capital ratio, what else should I look at before ...

    Learn about some of the financial leverage and profitability ratios that investors can analyze to supplement examining the ... Read Answer >>
  3. Over what duration should I be evaluating a company's total debt to total assets ...

    Learn what duration to use when analyzing the total debt to total assets ratio in a company and how to track a company's ... Read Answer >>
  4. What are the advantages and disadvantages of using the total debt to total assets ...

    Learn how the total debt to total assets ratio is beneficial to investors and lenders in assessing the solvency of a company ... Read Answer >>
  5. What is a bad interest coverage ratio?

    Understand how interest coverage ratio is calculated and what it signifies, and learn what market analysts consider to be ... Read Answer >>
  6. What's the difference between the coverage ratio and the levered free cash flow to ...

    Learn the differences between the equity evaluation metric, the levered free cash flow to enterprise value ratio and various ... Read Answer >>
Hot Definitions
  1. AAA

    The highest possible rating assigned to the bonds of an issuer by credit rating agencies. An issuer that is rated AAA has ...
  2. GBP

    The abbreviation for the British pound sterling, the official currency of the United Kingdom, the British Overseas Territories ...
  3. Diversification

    A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique ...
  4. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
  5. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  6. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
Trading Center