What Is the Asset Coverage Ratio?
The asset coverage ratio is a financial metric that measures how well a company can repay its debts by selling or liquidating its assets. The asset coverage ratio is important because it helps lenders, investors, and analysts measure the financial solvency of a company. Banks and creditors often look for a minimum asset coverage ratio before lending money.
- The asset coverage ratio is a financial metric that measures how well a company can repay its debts by selling or liquidating its assets.
- 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.
Understanding the Asset Coverage Ratio
The asset coverage ratio provides creditors and investors with the ability to gauge the level of risk associated with investing in a company. Once the coverage ratio is calculated, it can be compared to the ratios of companies within the same industry or sector.
It's important to note that the ratio is less reliable when comparing it to companies of different industries. Companies within certain industries may typically carry more debt on their balance sheet than others.
For example, a software company might not have much debt while an oil producer is usually more capital intensive, meaning it carries more debt to finance the expensive equipment, such as oil rigs but then again has assets on its balance sheet to back the loans.
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 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.
How the Asset Coverage Ratio is Used
Companies that issue shares of stock or equity to raise funds don't have a financial obligation to pay those funds back to investors. However, companies that issue debt via a bond offering or borrow capital from banks or other financial companies have an obligation to make timely payments and, ultimately, pay back the principal amount borrowed.
As a result, banks and investors holding a company's debt want to know that a company's earnings or profits are sufficient to cover future debt obligations, but they also want to know what happens if earnings falter.
In other words, the asset coverage ratio is a solvency ratio. 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 company earnings can not cover the debt.
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.
If earnings are not enough to cover the company's financial obligations, the company might be required to sell assets to generate cash. The asset coverage ratio tells creditors and investors how many times the company's assets can cover its debts in the event earnings are not enough to cover debt payments.
Compared to debt service ratio, asset coverage ratio is an extreme or last recourse ratio because the assets coverage is an extreme use of the assets' value under a liquidation scenario, which is not an extraordinary event.
There is one caveat to consider when interpreting the asset coverage 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.
Example of the Asset Coverage Ratio
For example, let's say Exxon Mobil Corporation (XOM) has an asset coverage ratio of 1.5, meaning that there are 1.5x's more assets than debts. Let's say Chevron Corporation (CVX)–which is within the same industry as Exxon–has a comparable ratio of 1.4, and even though the ratios are similar, they don't tell the whole story.
If Chevron's ratio for the prior two periods was .8 and 1.1, the 1.4 ratio in the current period shows the company has improved its balance sheet by increasing assets or deleveraging–paying down debt. Conversely, let's say Exxon's asset coverage ratio was 2.2 and 1.8 for the prior two periods, the 1.5 ratio in the current period could be the start of a worrisome trend of decreasing assets or increasing debt.
In other words, it's not enough to merely analyze one period's asset coverage ratio. Instead, it's important to determine what the trend has been over multiple periods and compare that trend with like companies.