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. It is by lenders, investors and analysts as a measure of financial solvency of a firm.

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 a company's debt want to know that a 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 in the event earnings are not enough to cover debt payments.

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.

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.

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.