The asset coverage ratio is a risk measurement that calculates a company’s ability to repay its debt obligations by selling its assets. It provides a sense to investors of how much assets are required by a firm to pay down its debt obligation. Companies generally have three sources of capital: debt, equity and retained earnings.
Definition – What is the Asset Coverage Ratio?
Equity investors are owners of the company, so if the company is not profitable they will not receive any returns on their investment. However, debt investors need to be paid interest (and principal in many cases) on a regular interval under all conditions. In situations when the company is not profitable, management might be forced to sell company assets in order to repay debt investors. Both equity and debt investors can use the total asset coverage ratio to get a theoretical sense of how much the assets are worth vs. the debt obligation of the company.
Analysts also use this ratio to gauge the financial stability, capital management, and overall riskiness of a company. The higher the ratio, the better it is from investor point of view because this means that assets drastically outnumber liabilities. A company, on the other hand, would like to maximize the amount of money it can borrow vs. maintaining a healthy asset coverage ratio.
Asset coverage ratio formula is calculated by subtracting the current liabilities less the short-term portion of long term debt from the totals assets less intangibles and dividing the difference by the total debt.
((Total Assets – Intangible Assets) – (Current Liabilities – Short-term Portion of LT Debt)) / Total Debt
All these items can easily be located in the balance sheet of a company’s annual report or the 10K SEC filing (for US listed companies). You might have to refer to the notes to accounts section to get the split of certain items in the formula.
a) ‘Total Assets’ refers to all the tangible and intangible assets of a company; from this value you remove the intangible assets
b) All current liabilities are added up and the resulting value is reduced from ‘short term debt’, the debt which is due in less than 1 year
c) The resulting value of step b is reduced from the final value in step a. The outcome of this step is divided by the total debt of the company to arrive at the asset coverage ratio
Now that we know how to calculate the asset coverage ratio equation, let’s take a look at some examples.
Let’s look at a hypothetical example of Company A. The financial data is summarized in the table below along with calculation of the ratio. As you can see the assets of the company has been increasing at greater pace compared to the debt, hence the coverage ratio has improved in the three years considered in the example.
Now we will consider a real world example of two Power utility companies in the US: Duke Energy & Southern Co. We have calculated the asset coverage ratio using the SEC 10K and presented the outcome in the table below:
The first thing to note is that, from 2014 to 2016, the asset coverage ratio has been above 1 for both the companies. This shows that the debt obligations are much less than the total amount of company assets and are well covered. In other words, the company would be able to pay off all of its debts without selling all of its assets. However, one key difference is that for Duke Energy the coverage ratio has been improving while for Southern Co it has been deteriorating.
Let us now interpret the ratio and extract key information about the financial health of the companies.
Analysis and Interpretation
Generally, asset coverage of over 1x is considered as a good sign; however, it will vary from industry to industry. For example, in utility companies a ratio of 1.0-1.5x is considered healthy while for capital goods companies a ratio of 1.5-2.0x is a norm.
Analysts don’t look at a ratio on a standalone basis; they compare the ratios across time period and with peers in the same industry. In the example of Company A above, we noted that the ratio is improving even when the debt is increasing. This could imply that the management is employing capital into productive purposes thus creating more assets. However, both companies are sitting in the mid of the industry average of 1.0-1.5x.
In the real world example of Duke and Southern, we can see that in the three year period, Duke has been able to improve its coverage while Southern has lagged behind. A closer look at the accounts and management discussion reveals that Duke has been reducing its debt while Southern has taken additional debt on its books. So does it mean that Southern is weaker than Duke? Not necessarily.
Ratios just provide a theoretical data point, but it needs to be interpreted from business standpoint. Analysts spend majority of their time in understanding the underlying factors behind these numbers. For example, Southern could be on an acquisition spree which could result in short-term pain but could be long term value accretive. The ratio should also be looked at from the point of industry dynamics as noted above.
In some cases a low coverage ratio might be well accepted by the lending community in a particular country. Analysts also use this ratio to gauge the execution of corporate strategy by the management. In a debt laden company investors would closely look for management guidance on the direction of deleveraging (the process of reducing debt in a company). The management could signal towards disposal of non-core assets and target ‘total debt reduction’ or a particular Asset coverage ratio. Such details can be found in the Management discussion section of a 10-K or the transcripts of the quarterly earnings calls.
Lenders, typically, have a set of covenants against which the borrowing is monitored. The terms also mention how much flexibility the company has on these covenants. This brings in a sense of discipline in the management, as the breach in any covenant can have negative financial or reputational impact such as fines, foreclosures or credit downgrades.
Usage Explanation – Cautions, and Limitations
Like with any ratio, especially the ones using balance sheet numbers, one needs to be cautious in using the asset coverage ratio. For one thing, it uses the book value of the asset which might be significantly different from the ‘replacement value’ or the ‘liquidation value’ of the asset. In case of fire-sale the assets might fetch significantly less value than reported in the balance sheet.
Analyst should also be careful to not to over interpret a single ratio. One should look at a whole array of financial ratios to get a clearer picture of the financial health of a company. Most relevant ratios in this case could be debt service ratio, LT debt ratio, Debt/Equity ratio etc.
In conclusion, in this article we have introduced an important tool to measure the financial stability of a company. However, you shouldn’t use this metric to analyze a company’s debt structure alone. It’s simple a measurement of how leveraged a company is and whether it has enough assets to pay off its liabilities.