Asset Coverage Ratio

What Is the Asset Coverage Ratio?

The asset coverage ratio is a financial metric that measures how well a company can repay its debts by selling or liquidating its assets. The asset coverage ratio is important on the grounds that it helps lenders, investors, and analysts measure the financial solvency of a company. Banks and creditors frequently search for a base asset coverage ratio before lending money.

Figuring out the Asset Coverage Ratio

The asset coverage ratio furnishes creditors and investors with the ability to check the level of risk associated with investing in a company. When the coverage ratio is calculated, it tends to be compared to the ratios of companies inside a similar industry or sector.

It's important to note that the ratio is less solid while contrasting it with companies of various industries. Companies inside certain industries may normally carry more debt on their balance sheet than others.

For instance, a software company probably won't have a lot of debt while an oil producer is normally more capital intensive, meaning it conveys more debt to finance the costly equipment, for example, oil fixes however at that point again has assets on its balance sheet to back the loans.

Asset Coverage Ratio Calculation

The asset coverage ratio is calculated with the following equation:

((Assets - Intangible Assets) - (Current Liabilities - Short-term Debt))/Total Debt

In this equation, "assets" alludes to total assets, and "intangible assets" are assets that can't be truly contacted, for example, goodwill or licenses. "Current liabilities" are liabilities due in something like one year, and "short-term debt" will be debt that is additionally due in one year or less. "Total debt" incorporates both short-term and long-term debt. These details can be found in the annual report.

How the Asset Coverage Ratio is Used

Companies that issue shares of stock or equity to raise funds don't have a financial obligation to pay those funds back to investors. Notwithstanding, companies that issue debt by means of a bond offering or borrow capital from banks or other financial companies have an obligation to make opportune payments and, at last, pay back the principal amount borrowed.

Thus, banks and investors holding a company's debt need to know that a company's earnings or profits are adequate to cover future debt obligations, however they likewise need to realize what occurs assuming that earnings waver.

All in all, the asset coverage ratio is a solvency ratio. It measures how well a company can cover its short-term debt obligations with its assets. A company that has a bigger number of assets than it does short-term debt and liability obligations shows to the lender that the company has a better chance of paying back the funds it loans in the event company earnings can not cover the debt.

The higher the asset coverage ratio, the more times a company can cover its debt. In this manner, a company with a high asset coverage ratio is viewed as safer than a company with a low asset coverage ratio.

In the event that earnings are sufficiently not to cover the company's financial obligations, the company may be required to sell assets to create cash. The asset coverage ratio tells creditors and investors how frequently the company's assets can cover its debts in the event earnings are sufficiently not to cover debt payments.

Compared to debt service ratio, asset coverage ratio is an extreme or last recourse ratio in light of the fact that the assets coverage is an extreme utilization of the assets' value under a liquidation scenario, which is certainly not an extraordinary event.

Special Considerations

There is one caveat to consider when deciphering the asset coverage ratio. Assets found on the balance sheet are held at their book value, which is frequently higher than the liquidation or selling value in the event a company would have to sell assets to repay debts. The coverage ratio might be somewhat swelled. This concern can be to some extent wiped out by looking at the ratio against different companies in a similar industry.

Illustration of the Asset Coverage Ratio

For instance, suppose Exxon Mobil Corporation (XOM) has an asset coverage ratio of 1.5, truly intending that there are 1.5x's a larger number of assets than debts. Suppose Chevron Corporation (CVX)- which is inside a similar industry as Exxon-has a comparable ratio of 1.4, and, surprisingly, however the ratios are comparative, they don't recount the whole story.

Assuming Chevron's ratio for the prior two periods was .8 and 1.1, the 1.4 ratio in the current period shows the company has further developed its balance sheet by expanding assets or deleveraging- paying down debt. On the other hand, suppose Exxon's asset coverage ratio was 2.2 and 1.8 for the prior two periods, the 1.5 ratio in the current period could be the beginning of a troubling trend of decreasing assets or expanding debt.

At the end of the day, it's adequately not to investigate one period's asset coverage ratio just. All things being equal, it's important to determine what the trend has been over different periods and compare that trend with like companies.

Highlights

The higher the asset coverage ratio, the more times a company can cover its debt.
In this manner, a company with a high asset coverage ratio is viewed as safer than a company with a low asset coverage ratio.
The asset coverage ratio is a financial metric that measures how well a company can repay its debts by selling or liquidating its assets.