Asset Coverage RatioDefined with Formula & More

Written By:
Adiste Mae

What is the Asset Coverage Ratio?

The Asset Coverage Ratio is a solvency ratio used to measure the ability of the company to pay its liabilities through the sale or liquidation of its assets.

Before investors or creditors extend additional funding to a company, the asset coverage ratio helps them determine the solvency of the company, making it an important financial measure.

The higher the asset coverage ratio is, the better. 

Understanding the Asset Coverage Ratio

Extending credit or investing in a company always comes with a risk but for investors or creditors to decide in doing so, the asset coverage ratio will be able to help them measure the risk of such an endeavor.

The ratio will also be used to compare companies across similar industries. 

Using the Asset Coverage Ratio to compare companies belonging to different industries will not be effective because there are industries that are capital intensive and require debt financing to purchase the assets it needs.

This means that some companies in a specific industry carry more debt than others. 

Industries belonging to construction and mining will require heavy equipment that is expensive.

Most often, companies purchase the equipment and machinery they use through debt.

In contrast, service industries are not capital intensive and will not require equipment or machinery to operate.

When companies belonging to these industries are compared using the asset coverage ratio, the results of the analysis will not be reliable. 

Asset Coverage Ratio Calculation

The formula to compute the Asset Coverage Ratio is:

Asset Coverage Ratio = ((Assets – Intangible Assets) – (Current Liabilities – Short Term Debt)) / Total Debt

The information required to compute the Asset Coverage Ratio can all be found on the Balance Sheet of the company. 

Intangible assets such as trademarks, patents, and copyrights are removed from the equation because it is not easy to value or sell these assets.

Current liabilities refer to the debt of the company that is expected to be paid within a year.

Short-term debts are subtracted from the equation because it is already included in the denominator (total debts). 

How the Asset Coverage Ratio is Used

There are different ways and means for companies to raise funds.

Public companies may do so by issuing shares of stocks that do not require them to pay back the amount invested to the shareholders.

If funds are raised through debt, the company is required to make timely payments until the full debt is paid. 

Lenders and other financial institutions would want to know if a company is able to pay back the loan should their earnings be not enough to cover it.

This makes the asset coverage ratio important to lenders because it signifies whether or not the company is solvent enough to make payments when its profitability fails. 

A high asset coverage ratio indicates that a company has more assets than debts.

This means that should it fail to pay back the debt, the lender will be able to recover the money lent through their assets.   

Special Considerations

When computing for the Asset Coverage Ratio, the assets are of higher value because the book value is taken instead of its selling or liquidating value.

Because of this, the asset coverage ratio may be inflated but when the ratio is compared across companies of the same industry, the issue related to asset inflation may be eliminated. 

Example of the Asset Coverage Ratio

Company X has an asset coverage ratio for the current year of 1.9 while Company A has 1.2 with both companies belonging to the same industry.

This means that Company X has more assets than liabilities compared to Company X and is, therefore, more solvent.

However, in the previous year, Company X’s asset coverage ratio was 1.1 and Company A’s was 1.4. 

The reason why Company X’s asset coverage ratio was higher in the current year is that they were able to settle most of their debts. 

When comparing companies belonging to the same industry, it is therefore not just wise to compare a current year’s asset coverage ratio but also take into consideration previous years.