Asset Coverage Ratio
Asset coverage ratio measures the ability of a company to cover its debt obligations with its assets. The ratio tells how much of the assets of a company will be required to cover its outstanding debts. The asset coverage ratio gives a snapshot of the financial position of a company by measuring its tangible and monetary assets against its financial obligations. This ratio allows the investors to reasonably predict the future earnings of the company and to asses the risk of insolvency.
Usually a minimum level of asset coverage ratio is defined in the covenants so that a company does not overextend its debts beyond a certain limit. The company would not be tempted to take too much loans; therefore chances of its insolvency are less. As a rule of thumb, industrial and publicly held companies should maintain an asset coverage ratio of 2 and utilities companies should maintain an asset coverage ratio of 1.5.
A higher asset coverage ratio indicates that a company has a stronger ability to meet its debt obligations, while a lower ratio indicates a weaker ability. It is mostly used by financial institutions and regulated companies. This ratio is used as a test of solvency by regulatory authorities and rating agencies.
The asset coverage ratio is calculated in three steps:
- Step 1: The current liabilities are added up and short term debt obligations are subtracted from this sum.
- Step 2: The book value of tangible and monetary assets of a company is calculated by subtracting the value of intangible assets (such as goodwill) from the book value of total assets. The figure calculated in Step 1 is subtracted from this figure.
- Step 3: The resulting figure of Step 2 is divided by the total outstanding debt of the company.
All of these three steps can be expressed in the following formula for asset coverage ratio.
Asset Coverage Ratio = ((Total Assets – Intangible Assets) – (Current Liabilities – Short-term Debt)) / Total Debt Obligations
A ratio benchmark is a standard or reference point for measuring the financial performance of a business. For example, a common ratio benchmark for asset coverage ratio is 1, meaning a company's assets equal its liabilities. A ratio greater than 1 indicates that a company has more assets than liabilities and is in good financial health. A ratio less than 1 indicates that a company has more debt than assets and is considered financially weak.
Another benchmark for the Asset Coverage Ratio for regulated companies is set by regulators and is usually greater than 1.
It's important to note that ratio benchmarks can vary depending on the industry or type of company being analyzed. For example, a ratio benchmark for a technology company may be different than a ratio benchmark for a retail company. Therefore, it's important to compare a company's ratios to industry averages or to the ratios of similar companies when analyzing its financial performance.
Asset Coverage Ratio should be used in conjunction with other financial ratios to get a more comprehensive understanding of a company's financial health. For example, the Debt-to-Equity Ratio and the Current Ratio provide information about a company's level of debt and liquidity, respectively, which can be used to supplement the information provided by the Asset Coverage Ratio. Additionally, comparing a company's Asset Coverage Ratio to industry averages or to the ratios of similar companies can provide insight into how the company compares to its peers. It's also important to consider other non-financial factors such as company's management, market conditions, competitors and future prospects when making investment decisions.