What Is the Asset Coverage Ratio?

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What Is the Asset Coverage Ratio?

Let me explain the asset coverage ratio directly: it's a fundamental financial metric that shows how well a company can pay off its debts by selling or liquidating its assets. You should know this because it helps lenders, investors, and analysts evaluate a company's financial solvency and overall risk. If the ratio is high, it means the company has plenty of assets to cover its debt, which reduces risk for lenders; a low ratio signals potential trouble in repaying debts. Banks and creditors often require a minimum ratio before approving loans—it's that straightforward.

Key Takeaways

Here's what you need to grasp: the asset coverage ratio directly measures a company's ability to repay debts through asset sales or liquidation. The higher this ratio, the more times the company can cover its debt obligations. As a result, a company with a high ratio presents less risk to creditors and investors compared to one with a low ratio—it's a clear indicator of financial stability.

Understanding the Asset Coverage Ratio

You can use the asset coverage ratio to assess the risk of investing in a company, as it lets creditors and investors see the debt burden clearly. Once you calculate it, compare it to ratios from other companies in the same industry or sector to check if the debt level is manageable relative to peers. Remember, this ratio isn't as reliable across different industries because some sectors naturally carry more debt. For instance, tech companies like Microsoft and Meta usually have low debt relative to their market cap due to their business model. On the other hand, capital-intensive firms like ExxonMobil in oil and gas often have higher debt to fund big-ticket items like oil rigs—Exxon reported $36.57 billion in long-term debt at the end of Q2 2024, but their vast assets keep the ratio healthy.

Asset Coverage Ratio Calculation

Calculating the asset coverage ratio is straightforward with this formula: subtract intangible assets from total assets, then subtract current liabilities minus short-term debt, and divide the result by total debt. Total assets include everything the company owns, while intangible assets are non-physical items like goodwill, patents, or trademarks. Current liabilities are debts due within a year, short-term debt is part of that, and total debt covers both short- and long-term obligations. You'll find all these figures on the company's balance sheet in its annual report—it's all there for you to verify.

How the Asset Coverage Ratio is Used

Companies raising funds through stock don't owe repayments, but issuing bonds or taking bank loans means regular payments and eventual principal repayment. That's why banks and debt investors check if earnings can cover these obligations and what happens if they can't. The asset coverage ratio, as a solvency metric, shows how well assets can cover short-term debts when earnings fall short. A high ratio means assets can cover debts multiple times, lowering lender risk. If earnings fail, the company might sell assets for cash, and this ratio tells you how many times assets could cover debts in that scenario. It's more drastic than the debt service ratio, representing a last-resort option in distress.

Special Considerations

One key point you must consider: balance sheet assets are at book value, which is often higher than what you'd get in a quick sale during debt repayment. This can inflate the ratio, making the company's position look better than it is. That's why comparing within the same industry is crucial for a realistic view.

Example of the Asset Coverage Ratio

Take Exxon Mobil Corporation (XOM) with a ratio of 1.5—it means they have 1.5 times more assets than debts. Compare that to Chevron Corporation (CVX) in the same industry with 1.4. If Chevron's prior ratios were 0.8 and 1.1, the jump to 1.4 shows improvement via asset growth or debt reduction. But if Exxon's were 2.2 and 1.8 before, dropping to 1.5 might signal a troubling trend of shrinking assets or rising debt. Don't just look at one period; track trends over time and against peers for the full picture.

How Is Asset Coverage Ratio Calculated?

You calculate it by subtracting intangible assets and current liabilities (excluding short-term debt) from total assets, then dividing by total debt. This assesses debt coverage via tangible assets, with all data from the balance sheet.

What Is a Good Asset Coverage Ratio?

A ratio over 1.0 is generally good, showing assets exceed debts, but 'good' varies by industry. Utilities might range from 1.0 to 1.5, while capital-intensive sectors prefer 1.5 to 2.0 or higher.

What Are The Limitations of the Asset Coverage Ratio?

Limitations include poor cross-industry comparisons and book values not matching liquidation values. Use it with other metrics for a complete financial assessment.

The Bottom Line

In summary, the asset coverage ratio evaluates debt repayment via assets, with higher ratios meaning lower risk, though ideals differ by industry. It has limitations, so pair it with metrics like debt-to-equity or interest coverage, and always compare over time and with peers for a thorough understanding.

What Is the Asset Coverage Ratio?

Highlights