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Asset Coverage Ratio is a risk analysis multiple that shows the amount of cash and tangible assets that are available to offset the debt and offers information about the company's ability to repay the debt by selling off the assets.
An investor can use it to estimate investment risk and forecast future earnings.
The asset coverage ratio is calculated with the following formula:
Asset Coverage Ratio = ( (Assets – Intangible Assets) – (Current Liabilities – Short-term Debt)) / Total Debt
For example, suppose a company has $100 million of total assets, $20 million of intangible assets, $30 million of current liabilities, $10 million of short-term debt, and $50 million of total debt. The asset coverage ratio of this company is:
Asset Coverage Ratio = (($100 million - $20 million) - ($30 million - $10 million)) / $50 million
Asset Coverage Ratio = ($80 million - $20 million) / $50 million
Asset Coverage Ratio = $60 million / $50 million
Asset Coverage Ratio = 1.2
This indicates that the company's tangible assets are 1.2 times more than its total debt. If the ratio is greater than 1, the corporation can pay off its debts using its assets. But a higher ratio is preferable because it shows that creditors have more room for error.
Asset Coverage Ratio = ( (Assets – Intangible Assets) – (Current Liabilities – Short-term Debt)) / Total Debt
In this equation, "assets" stands for total assets, and "intangible assets" refers to immovable assets like goodwill or patents. Current liabilities are obligations with a one-year payoff date, and short-term debt is debt with a one-year payoff date. The term "total debt" refers to both short- and long-term debt.
The risk of the examined organization decreases as the asset coverage ratio increases. To compare businesses in the same industry, the ratio can be utilized in comparable company analysis. It is less trustworthy when comparing businesses in different industries, though, as some may have more intangible assets or debt than others.
The asset coverage ratio assesses solvency, which refers to the capacity to pay off debt in the future. The asset coverage ratio is a metric that investors, debt holders, analysts, and other stakeholders use to evaluate a company's financial health, capital structure, risk level, and other factors.
Companies that issue bonds or borrow money from banks or other financial institutions should pay close attention to their asset coverage ratio. If the company defaults or files for bankruptcy, these creditors want to know that they will be repaid. As a covenant in the loan agreement, they might also demand a minimum asset coverage ratio.
For example, suppose a company has $100 million of total assets, $20 million of intangible assets, $30 million of current liabilities, $10 million of short-term debt, and $50 million of total debt. The asset coverage ratio of this company is:
Asset Coverage Ratio = (($100 million - $20 million) - ($30 million - $10 million)) / $50 million
Asset Coverage Ratio = ($80 million - $20 million) / $50 million
Asset Coverage Ratio = $60 million / $50 million
Asset Coverage Ratio = 1.2
This indicates that the company's tangible assets are 1.2 times more than its total debt. If the ratio is greater than 1, the corporation can pay off its debts using its assets. But a higher ratio is preferable because it shows that creditors have more room for error.
