Asset Coverage Ratio (Definition, Formula)

What is Asset Coverage Ratio?

Asset Coverage Ratio is a risk analysis multiple which tells us if the company’s ability to repay the debt by selling off the assets and provides details of how much of the monetary and tangible assets are there against the debt which helps an investor to predict the future earnings and gauge the risk involved in the investment.

Generally, a minimum ratio is already defined by the authorities for the companies to maintain a specific level of debt so that there is a balance in the company’s leverage position. Higher the ratio, higher is the investment favorability, since the high ratio denotes that the assets of the company outweigh the liabilities and the company is financially stable with effective capital management.

Asset Coverage Ratio Formula

Asset Coverage Ratio = (Total Assets – Intangible Assets) – (Current Liabilities – Short term portion of long-term debt) / Total Debt

Examples

Let us understand the ratio with two examples, in the first one we will calculate the ratio of an individual company and in the second example, we will try to calculate and evaluate the ratio of 2 companies from the same industry.

You can download this Asset Coverage Ratio Excel Template here – Asset Coverage Ratio Excel Template

Example #1

Let us assume that below is the data for the Netflix for the year 2017-2019, now let us calculate the asset coverage ratio for them.

Solution

=((200-80)-(40-30))/150
=0.73

Asset Coverage Ratio for the year 2017, 2018, 2019 is as follows –

From the above example, we can see that the ratio for Netflix has improved from 2017 to 2019, we will interpret and discuss this ratio in the next section.

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Example #2

Let us compare two telecom giants in USA T-Mobile and Verizon whose Asset coverage ratio we calculate using the formula.

Interpretation and Analysis of Asset Coverage Ratio

The higher ratio tells us that the company has enough assets to repay its debt and lower ratio signifies that the liabilities outweigh the assets and risk factor is involved.

Example 1:

We can see that Netflix’s Asset coverage ratio decreases from 0.73 in 2017 to 0.64 in 2018, but then increases drastically from 2019 to 1.35. So, Netflix initially in 2017 has assets to cover only 0.73 portions of its liability whereas in 2018 it went down further which means the company is either taking more debt or is selling off its assets which makes the ratio go down. In 2019, the ratio shoots up to 1.35 which says either that the company has repaid a portion of its long-term debt of the company is expanding with effective production management by investing in more Fixed Assets.

Example 2:

Asset Coverage Ratio for T-Mobile and Verizon for the years 2017, 2018 and 2019 is 1.2, 1.3 and 1.35. We can clearly see that there is a lot of movement in T-Mobile from 1.3 to 0.9 and finally to 1.1. Whereas, comparatively Verizon comes across as a stable company maintaining the ratio year on year. It doesn’t necessarily mean that Verizon is a better investment avenue than T-Mobile, there a numerous other factors which needs to be considered before making the final decision. It might be a possibility that T-Mobile is planning to launch a range of new services in the market and for that it is increasing the debt on its balance sheet.

On the other hand, Verizon is playing safe by maintaining the standard ratio without any new launch, a short tern dent might be to gain long term benefits. This ratio just tells us the debt and assets balance of any company at a particular time period, then it is the analyst’s job to consider other factors before making the final call.

Advantages

This ratio can act as an indicator for the company to make future decisions about investment and expanding, if the ratio is getting lower year on year then the company might see this as the right time for investment as it will boost this ratio.
Also, this ratio can be best utilized if it is combined with effective management decisions which can be found in the annual filing report or quarterly meetings.

Disadvantages

One of the major disadvantages of this ratio is that it uses Balance sheet figures and that too at Book value and not the liquidating or market price.
Also, an analyst should not concentrate only on this ratio to make the decision he/she should also consider plenty of other financial ratios to get a clear picture of the company.

Conclusion

Asset coverage ratio if used efficiently can prove to be a great resource for the analysts, certain other factors also need to be considered along with this ratio to make an informed decision. It is helpful for both the investors, equity or debt and comparing the ratio with a competitor and industry-standard can give a clear picture of the financial health of any company.