Asset Coverage Ratio
What is asset coverage ratio?
Investment analysts often discuss the asset coverage ratio of various companies; but what is asset coverage ratio? Most authorities define the asset coverage ratio as a measure of a specific company’s ability to cover the amount of its existing debts. Essentially, an asset coverage ratio measures the tangible physical and monetary assets of a company against its outstanding debts and overall liability to derive a snapshot of the company’s current financial situation. This measure is usually part of a larger liquidity analysis, which takes into consideration factors like cash on hand, long-term financial obligations, and current liquidity assessments.
Asset coverage ratio formula
While a number of variants exist, the general asset coverage ratio formula is determined by adding up all current financial liabilities, excluding short-term financial outlays, for the company; this amount is then subtracted from the total current value of physical and monetary assets, not including intangible assets such as customer good will or market placement. The resulting figure is divided by the total outstanding corporate liabilities to derive a decimal number; higher ratios indicate a better financial situation. Essentially, the asset coverage ratio formula can be expressed as:
• ((Current value of total physical and monetary assets, excluding intangibles) - (Total current liabilities, excluding short-term liabilities)) / Total amount of outstanding corporate debt
Experts agree that for utilities, the resulting asset coverage ratio should be at least 1.5, while most industries require an asset coverage ratio of 2.0. In order to gain an accurate measure, it’s essential that physical assets be assessed at their actual depreciated value, and not at their original cost basis or simply by applying a “book” value. Failure to do so may result in artificially high asset coverage ratio figures and an overly optimistic view of the company’s financial situation.
Fixed asset coverage ratio
The fixed asset coverage ratio is a measure of how effectively a company is using its facilities and real property to produce financial results. Also known as the fixed asset turnover ratio, this measure of financial liquidity is derived by dividing the net sales of a company by the average net value of its fixed assets. The fixed asset coverage ratio formula can be shown as follows:
• (Net sales) / (Current average value of fixed assets)
Higher ratios are preferable. While fixed asset coverage ratio figures are not usually made publicly available, many investment analysts incorporate them into their assessments of a company’s overall health and real value; thus, the fixed asset coverage ratio can have a significant effect on the valuation of corporate stocks and future earnings.
Minimum asset coverage ratio
In order to protect shareholders, many companies incorporate a minimum asset coverage ratio; this is usually established by covenant. This ensures that the company cannot overextend itself financially or enter into unwise expenditures. Since the company is required to maintain a healthy asset coverage ratio, it is less likely to become insolvent. Over time or if exceptional circumstances apply, companies may petition their shareholders to lower the minimum asset coverage ratio; this may be done on a permanent or temporary basis. In general, publicly-held companies are expected to maintain a minimum asset coverage ratio of greater than 1.5.
Asset coverage ratio analysis is useful in determining likely financial performance for publicly-held industrial and utility companies. It offers a current snapshot of the company’s financial position, allowing investors to make accurate predictions of future earnings and to assess the overall financial health of the company. Most investment experts incorporate these useful measurements into their general analysis of a company’s public stock offerings.