Asset Coverage Ratio

What is Asset Coverage Ratio?

The asset coverage ratio is a financial indicator that helps measure a company's ability to repay debts by selling or liquidating its assets. It is significant since it helps lenders, investors, and analysts to determine a company's financial solvency.

Banks and creditors prefer a lower asset coverage ratio for lending money. Usually, they have a minimum ratio threshold, over which they don’t lend money.

If a business does not make enough profit, then investors will not be able to profit from their investments. Regardless of the circumstances, debt investors must be paid interest and principal in case of repayment.

If a company is unsuccessful, then its management may be forced to sell some of its assets to repay creditors. The asset coverage ratio formula should be used to understand the assets' real worth when compared to liabilities and other payment obligations.

At the same time, financial analysts use this ratio to assess a firm's financial stability, capital management, and the level of risk associated with investing in the company. Generally speaking, the higher the ratio, the better for investors.

A good coverage ratio means that the total value of assets exceeds the value of payment obligations many times over.

The asset coverage ratio is a crucial financial metric for determining a company's solvency and health. In addition, it provides an insight into the company's leverage and asset backup condition. However, this ratio has limitations.

Analysts and stakeholders should combine this ratio with other financial measures such as the Debt to Equity ratio and the Interest Coverage Ratio when evaluating a company's financial status and standing.

Understanding the Asset Coverage Ratio

The asset coverage ratio helps creditors and investors understand the risk level that comes with investing in a company. It can be compared to the ratios of companies within the same industry or sector to assess this risk appropriately.

When comparing firms from different sectors, it's essential to remember that the ratio might not be useful as certain industries may have higher debt levels on their balance sheets than others.

Asset coverage of more than 1x is generally seen as positive; however, this varies by industry. For example, a ratio of 1.0x - 1.5x is seen as good in utility companies, while 1.5 - 2.0x is usual in capital goods companies.

Stakeholders should use asset coverage ratios with caution when making financial decisions. A distress sale occurs when a company is forced to sell its assets to meet its debt obligations.

So, the assets will sell for a fraction of their book value. This sum may not be sufficient to meet the company's whole debt obligation. It might also be the other way around for landed properties with a higher real market value.

Stakeholders may think that if a company's asset coverage ratio is 1.2 in a given fiscal year, everything is well. However, a comparison of this ratio across time is necessary.

For example, the company's Asset Coverage Ratio may be declining year after year. This should be a cause for concern for any investor, as it indicates that either the assets are depreciating or the debt is expanding.

Asset Coverage Ratio Formula

This ratio delves deep into a company's ability to cover its debt obligations using its tangible assets, excluding any intangible ones. It provides a snapshot of the safety cushion available to a company's lenders in the unfortunate event of a liquidation.

The formula is as follows:

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

• "Assets" refers to total assets. In contrast, "Intangible Assets" are assets that can't be touched or seen, such as goodwill or patents.
• "Current Liabilities" are obligations that are due within a year, and "Short-term Debt" is debt that is due within a year as well.
• The term "Total Debt" encompasses both short and long-term debt. The yearly report contains all of these line items.

Listed below are the steps to calculate the asset coverage ratio:

1. Extract the final balances of all assets from the financial statements.
2. Subtract the amounts reported on the books for any intangible assets from the sum of these assets. This deduction is based on the premise that intangible assets can't be converted into cash; if this isn't the case, don’t subtract intangibles with a conversion value.
3. All current liabilities, excluding those related to short-term debt, should be extracted from the financial statements.
4. Subtract the net liabilities value from the net asset figure calculated in step 2 in step 3. The number of assets available to pay down debts should be the result.
5. Divide the net amount derived in step 4 by the ending book balance of all debt outstanding.

Usage of Asset coverage ratio

Different types of ratios are used by lenders and financial organizations to assess a company's financial solvency. The asset coverage ratio is a widely used metric for determining whether a company's assets are sufficient to cover its obligations and liabilities if its earnings fall short of expectations.

A high asset coverage ratio implies that a company's assets are sufficient to cover its debts, while a low asset coverage ratio suggests that the opposite is true.

Companies require capital to run their operations; there are two basic ways for a company to obtain capital: debt or equity financing. Debt and equity vary because debt must be repaid back to third-party lenders, but equity does not.

To understand the main usage of the ratio, let's take a look at the below list:

1. An asset coverage ratio is a valuable tool for determining how exposed a company is to bankruptcy.
2. It is a solvency ratio, which means it understands a company's capacity to meet the future debt.
3. If a firm has more assets than short-term debt and liabilities, the lender believes it has a higher chance of repaying the funds it lends if the company's profits are insufficient to service the debt.
4. The asset coverage ratio indicates how many times a corporation can cover its debt. As a result, a corporation with a high asset coverage ratio is thought to be safer than one with a low asset coverage ratio.
5. A corporation does not want the ratio to be too high because it could suggest that it is not taking on enough debt and is not optimizing shareholder returns.

Example of the Asset Coverage Ratio

Let’s look at an example of Company A. Its financial data is given in the table below, along with the ratio calculation. Its assets have been growing at a greater pace compared to the debt. So the coverage ratio has improved in the three years considered in the example.

In the example of Company A above, we saw that the ratio is improving even when the debt is increasing. This means that the management is employing capital for productive purposes, thus creating more assets. Both companies are in the middle of the industry average of 1.0-1.5x.

Next, we will consider a real-world example of two utility companies in the US: Duke Energy & Southern Co. We have calculated the relevant ratio using the SEC 10K, and the findings are below:

• The first thing to notice is that both companies' asset coverage ratios were greater than 1 from 2014 to 2016.
• This shows that the debt is significantly lower than the overall value of the company's assets. 
• In other words, the corporation would be able to pay off all of its debts without selling off all of its assets.
• However, one significant distinction is that Duke Energy's coverage ratio is improving while Southern Co's is worsening.

Limitations of Asset Coverage Ratio

Some of the limitations of the ratio are:

1. Similarity

The asset coverage ratio can be used to compare a company’s risk profile. Yet companies in different sectors or at different life cycle stages may use different capital structures that make comparison impossible.

2. Accuracy

The components of the asset coverage ratio are items from the balance sheet. In most cases, the items are measured at book value and may not reflect the actual current market value.

In addition, accounting profits are not cash flow items and can be changed by accounting methods. However, it can be changed, so the investor needs to be careful while using the coverage ratios.

3. Ratios ignore inflationary pricing movements

Many ratios are established based on historical costs, ignoring price changes between periods. This does not accurately reflect the financial condition.

4. Accounting ratios entirely disregard the firm's qualitative features

They simply analyze the financial sides of the situation (quantitative).

5. There are no universally accepted definitions for the ratios

As a result, the same companies may use new formulas for the ratios.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Asset Management
• Asset Turnover Ratio
• Interest Coverage Ratio
• Interest Coverage Ratio
• Justified Price to Earnings Ratio