Asset Coverage Ratio

This is an in-depth guide on how to calculate Asset Coverage Ratio with through interpretation, analysis, and example. You will learn how to use its formula to evaluate a firm's debt repayment capacity.

Definition - What is Asset Coverage Ratio?

When you’re considering investment in a company, there are a variety of tools available to you to determine whether it is worthwhile or not.

One of these tools is the Asset Coverage Ratio which is the measurement used to determine a firm's ability to pay off or cover its debt given its assets.

This is an especially important ratio in helping you to understand whether or not the company’s assets can cover any debts owed to you and other investors.

If a company is unable to pay its debts, selling off these assets might be the only solution.

When analyzing the ratio, the broad consensus is the higher the coverage ratio, the better as it reflects the ability of the business to fulfill its debt obligations against its assets.

In using this ratio, analysts tend to take the view that for Utilities companies, the asset coverage ratio should be at least 1.5 whereas industrial companies should have a ratio of at least 2.

Anything below these respectively would signal that the company does not have the ability to pay back all of its debts given its assets.

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Formula

The simplest way for you to calculate the ratio is by using the following formula:

Asset Coverage Ratio = ((Assets - Intangible Assets) - (Total Current Liabilities - Short-term Debt)) / Total Debt

This information can be found easily on the company's balance sheet and other financial statements.

  • “Assets” refers to the total company assets
  • “Intangible assets” are assets that are not physical e.g. goodwill.
  • “Short-term Debts” are those that are due within one year.
  • “Total Debt” is all outstanding short and long term debt.

Example

ABC Co is an investment company and has the following on its financial statements:

  • Tangible Assets (Total Assets - Intangible Assets): $2,350m
  • Current Liabilities: $870m
  • Short-Term Debts: $624m
  • Total Debts: $900m

We would substitute this into the equation as follows:

ABC Co’s Asset Coverage ratio is 2.34 which suggests that ABC Co does have the ability to pay off its debts given its assets.

As we are analyzing an investment company, this ratio would have had to have been over 2 to be acceptable to investors.

Another example of a company in a different industry is as follows:

XYZ Co is a Utilities company and has the following on its financial statements.

  • Tangible Assets (Total Assets - Intangible Assets) = $4,100m
  • Current Liabilities = $1,935m
  • Short-Term Debts $76m
  • Total Debts $1,850m

We would substitute this into the equation as follows:

XYZ Co’s Asset Coverage ratio is 1.21 which would suggest to investors that there would be a strong likelihood that XYZ would not have the ability to pay off its debts given the assets it has to draw upon.

As we are analyzing a Utilities company, this ratio would have had to have been over 1.5 to be acceptable to investors.


Interpretation & Analysis

When a company’s asset coverage ratio is above its recommended guideline (1.5 or 2 respectively), it suggests that the company has enough assets compared to its total borrowings and thus is more likely down the road to pay off its outstanding debts.

So what is a good asset coverage ratio?

The higher the ratio, the better as this reflects how many times over the company can cover its debt and is thus deemed less risky.

When a company's asset coverage value is below the recommended guideline for its industry, this suggests that it has insufficient assets that it would be able to draw upon in the event it should need to pay its debts back to you.

The closer to the industry guideline the ratio falls, the riskier the company.


Cautions & Further Explanation

One of the major flaws of this ratio is that it is based on a company’s ‘book value’ which may inflate the ratio and thus portray an overly optimistic reflection of the company and its ability to cover its debts.

To avoid this, analysts can instead value the assets at their actual depreciated value rather than their book value which would provide a much more realistic representation of the company’s asset ability versus its debt.

If you’re using the ‘book value’ then another way to reduce the possibility of skewed results would be to compare the ratio against other asset coverage results from similar companies in the same industry which would give you a better understanding of the reliability of the result.

Overall this ratio would likely be more informative for you when used alongside several other performance and coverage ratios in order to develop an all round, accurate view of a company and its abilities.

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Hung Nguyen
 

Entrepreneur, independent investor, instructor and a visionary of my team here. I've been playing with stocks and sharing my knowledge to the world. The stock market is cool, and I love it!

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