Asset Coverage Ratio
What is '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.