What is asset coverage ratio?
Asset coverage ratio measures the ability of a company to cover its debt obligations by selling its assets. The ratio tells how much of the assets of a company will be required to wrap up its outstanding debts.
This ratio provides a sense to investors of how much assets are required by a firm to pay off its debt obligation. Equity investors are owners of the company. So if the company is not profitable they will not receive any returns on their investment.
However, debt investors need to be paid interest (and principal in many cases) on a regular interval under all conditions. In situations when the company is not profitable, management might be forced to sell company assets in order to repay debt investors.
Both equity and debt investors can use the entire asset coverage ratio to urge a theoretical sense of what quantity the assets are worth vs the debt obligation of the company.
The asset coverage ratio gives a picture 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 assess the risk of insolvency. Companies generally have three sources of capital: debt, equity and retained earnings.
Financial analysts are using this ratio to get the financial stability, capital management, and overall risk pertaining of a company. The higher the ratio, the better it is from investor point of view because this means that assets drastically overcome the liabilities. A company, on the other hand, would like to maximize the amount of money it can borrow vs. maintaining a healthy asset coverage ratio.
Advantage of asset coverage ratio
- With the help of trend analysis of the this ratio provides a clear picture of the stability of the company
- It guesses about capital management, and overall riskiness of a company.
- It provides the company to assess the risk of insolvency.
- It’s useful for both equity and debt investors.
- It calculate its tangible and monetary assets against its financial obligations.
- credit worthiness of the company
- It is an indicator for other stakeholders such as investors, creditors, employees, etc. to take timely decisions.
Disadvantage of asset coverage ratio
- This ratio is not predicting right figure of the firm’s situation of for a given period.
- It is unable to give the true picture of the company’s position as there can be seasonal factors which can hide / distort the ratio.
- It does not consider the effect of Tax Expense to the organization.
Calculation (formula) asset coverage ratio
There are three steps to calculate coverage ratio:
- Step 1: Total Assets refers to all the tangible and intangible assets of a company; from this value you remove the intangible assets such as goodwill, brand value from the book value of total assets.
- Step 2: The current liabilities are added up and short term debt obligations are subtracted from this sum.
- Step 3: The resulting figure of Step 1 minus step 2 is split by the whole outstanding debt of the organization.
All of those three steps may be expressed within the following formula for asset coverage ratio:
Asset Coverage Ratio = ((Total Assets – Intangible Assets) – (Current Liabilities – Short-term Debts portion of LT Debts)) / Total Debt Obligations
Read| Net Working Capital
Fixed Assets Ratio:
This ratio establishes the link between long run funds (equity plus long-term loans) and fixed assets. Since financial management advocates that fixed assets should be purchased out of long run funds only.
Following formula or equation is employed to calculate fixed assets ratio:
Fixed Assets ratio = Net fixed assets / Long term funds.
Analysis and Interpretation Asset Coverage Ratio
Generally, asset coverage of over 1x is considered as a good sign; however, it will vary from company to company. 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.
Analysts don’t look at a ratio on a standalone basis; they compare the ratios across time period and with peers in the same industry.
Ratios just provide a theoretical data point, but it needs to be interpreted from business standpoint. Analysts spend majority of their time to understand the underlying factors behind these numbers
In some cases a low coverage ratio might be well accepted by the lending community in a particular country. Analysts also use this ratio to guess the execution of corporate strategy by the management.
Lenders, typically, have a set of covenants against which the borrowing is monitored. The terms also mention how much flexibility the company has on these covenants.
This brings in a sense of discipline in the management, as the breach in any covenant can have negative financial or reputational impact such as fines, foreclosures or credit downgrades.
Let’s an example, a company’s financials include:
- Total assets: $170 million
- Intangible assets: $30 million
- Current liabilities: $30 million
- Short-term debt: $20 million
- Total debt: $100 million
Asset coverage Ratio = (($170 million – $30 million) – ($30 million – $20 million)) / $100 million = 1.3x
Therefore, the company would be able to pay off all of its debts without selling all of its assets.