What is the Asset Coverage Ratio?
The asset coverage ratio is the numerical representation that calculates the ability of a company to repay its debts by selling or liquidating its tangible assets. The asset coverage ratio helps investors, creditors, regulatory bodies, etc. identify the financial solvency of a company. In other words, it enables investors and lenders to determine the level of risk associated with investing in a company.
A company with a higher asset coverage ratio is less exposed to bankruptcy risk. Hence, from the creditor’s or investor’s perspective, the higher the ratio, the better it is because it indicates that the assets outnumber liabilities.
How to Calculate Asset Coverage Ratio
Here is the formula to calculate the asset coverage ratio:
((Assets – Intangible Assets) – (Current Liabilities – Short-term Debt)) / Total Debt
Where:
- Assets: Is the total assets
- Intangible assets: These are assets non-physical assets like goodwill, copyrights, franchises, trademarks, patents, securities, etc.
- Current liabilities: Are liabilities due within one year
- Short-term debt: Is a debt due within one year
- Total debt: Is both short and long-term debt
For example, Company A has a total assets of $100, intangible assets of $30, current liabilities of $20, short-term debt of $10 and total debt of $100.
The ratio would be = ((100 – 30) – (20 – 10))/ 100
= 0.60
After calculating the coverage ratio, you can compare it to the ratios of peers in the same industry or sector. However, asset coverage ratio can’t be a standalone factor when comparing it to companies of different industries.
Because companies within certain industries tend to incur less debt on their balance sheet than others. For example, airlines, and oil and gas companies are usually more capital intensive as compared to software companies, because they need more debt to finance the expensive fleets of aircraft, or equipment, such as oil rigs. However, these companies have assets on their balance sheet as collateral against the loan.
Understanding Asset Coverage Ratio
When a company issues shares of stock or equity to raise funds, it has no financial obligations to pay those funds back to investors. However, a company that issues debt via a bond offering or borrow money from lenders has an obligation to repay the debt time to time and, ultimately, pay back the principal amount owed.
So, lenders or investors that lend money to a company want to determine whether the company has sufficient earnings or profits to cover future debt obligations. Investors/ lenders also want to know how a company would cover its debt obligation if its earnings falter.
If the assets of a company outnumber the short-term debt and liabilities, it means the company has a better chance of paying back the funds it borrowed even if earnings can’t cover the debt. When the profits or earnings are not enough to cover the company’s financial obligations, the company can sell or liquidate its assets to generate cash.
The asset coverage ratio indicates how many times the company’s assets can cover its debt in case of insufficient earnings to cover debt payments. Therefore a company with a high coverage ratio is considered to be less risky as compared to a company that has a low asset coverage ratio.
Example of Asset Coverage Ratio
For example, a telecom company Xillirion has an asset coverage ratio of 2.5 i.e. there are 2.5x more assets than debt obligations. The other company, let’s say Rivon, which is in the same industry as Xillirion, has an asset coverage ratio of 2.4. While the ratios may look similar, the circumstances may differ.
However, if Xillirion’s asset coverage ratio for two previous periods was 1.7 and 2.3, the current ratio of 2.5 indicates the company has improved its balance sheet by increasing assets or paying the debt obligations. Conversely, if Rivon’s ratios for previous periods were 2.8 and 2.6, the current ratio of 2.4 could raise a red flag for investors or lenders because of declining assets or increasing debts.
It means that analyzing only one period’s coverage ratio is not enough. It is important to find out the trends over multiple periods and compare the same with companies within the same industry.
Special Consideration
It is important to note that assets reported on the balance sheet are held at their book value, which is typically higher than the selling or liquidation value if the company would be selling these assets to repay debts. So, the ratio may be slightly higher. To some extent, this doubt can be cleared by comparing the coverage ratio of a company with that of other peer companies.
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