What Is the Asset Coverage Ratio?

The asset coverage ratio is a financial metric that measures how well a company can repay its debts by selling or liquidating its assets. The asset coverage ratio is important because it helps lenders, investors, and analysts measure the financial solvency of a company. Banks and creditors often look for a minimum asset coverage ratio before lending money.

Understanding the Asset Coverage Ratio

The asset coverage ratio provides creditors and investors with the ability to gauge the level of risk associated with investing in a company. Once the coverage ratio is calculated, it can be compared to the ratios of companies within the same industry or sector.

It’s important to note that the ratio is less reliable when comparing it to companies of different industries. Companies within certain industries may typically carry more debt on their balance sheet than others.

For example, a software company might not have much debt while an oil producer is usually more capital intensive, meaning it carries more debt to finance the expensive equipment, such as oil rigs but then again has assets on its balance sheet to back the loans.

Asset Coverage Ratio Calculation

The asset coverage ratio is calculated with the following equation:

((Assets – Intangible Assets) – (Current Liabilities – Short-term Debt)) / Total Debt

In this equation, “assets” refers to total assets, and “intangible assets” are assets that can’t be physically touched, such as goodwill or patents. “Current liabilities” are liabilities due within one year, and “short-term debt” is debt that is also due within one year. “Total debt” includes both short-term and long-term debt. All of these line items can be found in the annual report.

How the Asset Coverage Ratio is Used

Companies that issue shares of stock or equity to raise funds don’t have a financial obligation to pay those funds back to investors. However, companies that issue debt via a bond offering or borrow capital from banks or other financial companies have an obligation to make timely payments and, ultimately, pay back the principal amount borrowed.

As a result, banks and investors holding a company’s debt want to know that a company’s earnings or profits are sufficient to cover future debt obligations, but they also want to know what happens if earnings falter.

In other words, the asset coverage ratio is a solvency ratio. It measures how well a company can cover its short-term debt obligations with its assets. A company that has more assets than it does short-term debt and liability obligations indicates to the lender that the company has a better chance of paying back the funds it lends in the event company earnings can not cover the debt.

The higher the asset coverage ratio, the more times a company can cover its debt. Therefore, a company with a high asset coverage ratio is considered to be less risky than a company with a low asset coverage ratio.

If earnings are not enough to cover the company’s financial obligations, the company might be required to sell assets to generate cash. The asset coverage ratio tells creditors and investors how many times the company’s assets can cover its debts in the event earnings are not enough to cover debt payments.

Compared to debt service ratio, asset coverage ratio is an extreme or last recourse ratio because the assets coverage is an extreme use of the assets’ value under a liquidation scenario, which is not an extraordinary event.

Special Considerations

There is one caveat to consider when interpreting the asset coverage ratio. Assets found on the balance sheet are held at their book value, which is often higher than the liquidation or selling value in the event a company would need to sell assets to repay debts. The coverage ratio may be slightly inflated. This concern can be partially eliminated by comparing the ratio against other companies in the same industry.

Example of the Asset Coverage Ratio

For example, let’s say Exxon Mobil Corporation (XOM) has an asset coverage ratio of 1.5, meaning that there are 1.5x’s more assets than debts. Let’s say Chevron Corporation (CVX)–which is within the same industry as Exxon–has a comparable ratio of 1.4, and even though the ratios are similar, they don’t tell the whole story.

If Chevron’s ratio for the prior two periods was .8 and 1.1, the 1.4 ratio in the current period shows the company has improved its balance sheet by increasing assets or deleveraging–paying down debt. Conversely, let’s say Exxon’s asset coverage ratio was 2.2 and 1.8 for the prior two periods, the 1.5 ratio in the current period could be the start of a worrisome trend of decreasing assets or increasing debt.

In other words, it’s not enough to merely analyze one period’s asset coverage ratio. Instead, it’s important to determine what the trend has been over multiple periods and compare that trend with like companies.

What Is Asset/Liability Management?

Asset/liability management is the process of managing the use of assets and cash flows to reduce the firm’s risk of loss from not paying a liability on time. Well-managed assets and liabilities increase business profits. The asset/liability management process is typically applied to bank loan portfolios and pension plans. It also involves the economic value of equity.

Understanding Asset/Liability Management

The concept of asset/liability management focuses on the timing of cash flows because company managers must plan for the payment of liabilities. The process must ensure that assets are available to pay debts as they come due and that assets or earnings can be converted into cash. The asset/liability management process applies to different categories of assets on the balance sheet.

[Important: A company can face a mismatch between assets and liabilities because of illiquidity or changes in interest rates; asset/liability management reduces the likelihood of a mismatch.]

Factoring in Defined Benefit Pension Plans

A defined benefit pension plan provides a fixed, pre-established pension benefit for employees upon retirement, and the employer carries the risk that assets invested in the pension plan may not be sufficient to pay all benefits. Companies must forecast the dollar amount of assets available to pay benefits required by a defined benefit plan.

Assume, for example, that a group of employees must receive a total of $1.5 million in pension payments starting in 10 years. The company must estimate a rate of return on the dollars invested in the pension plan and determine how much the firm must contribute each year before the first payments begin in 10 years.

Examples of Interest Rate Risk

Asset/liability management is also used in banking. A bank must pay interest on deposits and also charge a rate of interest on loans. To manage these two variables, bankers track the net interest margin or the difference between the interest paid on deposits and interest earned on loans.

Assume, for example, that a bank earns an average rate of 6% on three-year loans and pays a 4% rate on three-year certificates of deposit. The interest rate margin the bank generates is 6% – 4% = 2%. Since banks are subject to interest rate risk, or the risk that interest rates increase, clients demand higher interest rates on their deposits to keep assets at the bank.

The Asset Coverage Ratio

An important ratio used in managing assets and liabilities is the asset coverage ratio which computes the value of assets available to pay a firm’s debts. The ratio is calculated as follows:


$\begin{aligned} &\text{Asset Coverage Ratio} = \frac{ ( \text{BVTA} – \text{IA} ) – ( \text{CL} – \text{STDO}) }{ \text{Total Debt Outstanding} } \\ &\textbf{where:} \\ &\text{BVTA} = \text{book value of total assets} \\ &\text{IA} = \text{intangible assets} \\ &\text{CL} = \text{current liabilities} \\ &\text{STDO} = \text{short term debt obligations} \\ \end{aligned}$​Asset Coverage Ratio=Total Debt Outstanding(BVTA−IA)−(CL−STDO)​where:BVTA=book value of total assetsIA=intangible assetsCL=current liabilitiesSTDO=short term debt obligations​

Tangible assets, such as equipment and machinery, are stated at their book value, which is the cost of the asset less accumulated depreciation. Intangible assets, such as patents, are subtracted from the formula because these assets are more difficult to value and sell. Debts payable in less than 12 months are considered short-term debt, and those liabilities are also subtracted from the formula.

The coverage ratio computes the assets available to pay debt obligations, although the liquidation value of some assets, such as real estate, may be difficult to calculate. There is no rule of thumb as to what constitutes a good or poor ratio since calculations vary by industry.

Key Takeaways

• Asset/liability management reduces the risk that a company may not meet its obligations in the future.
• The success of bank loan portfolios and pension plans depend on asset/liability management processes.
• Banks track the difference between the interest paid on deposits and interest earned on loans to ensure that they can pay interest on deposits and to determine what a rate of interest to charge on loans.

[Fast Fact: Asset/liability management is a long-term strategy to manage risks. For example, a home-owner must ensure that they have enough money to pay their mortgage each month by managing their income and expenses for the duration of the loan.]

What Is Asset Management?

Asset management is the practice of increasing total wealth over time by acquiring, maintaining, and trading investments that have the potential to grow in value.

Asset management professionals perform this service for others. They may also be called portfolio managers or financial advisors. Many work independently while others work for an investment bank or other financial institution.

Understanding Asset Management

Asset management has a double-barreled goal: increasing value while mitigating risk. That is, the client’s tolerance for risk is the first question to be posed. A retiree living on the income from a portfolio, or a pension fund administrator overseeing retirement funds, is (or should be) risk-averse. A young person, or any adventurous person, might want to dabble in high-risk investments.

Most of us are somewhere in the middle, and asset managers try to identify just where that is for a client.

The asset manager’s role is to determine what investments to make, or avoid, to realize the client’s financial goals within the limits of the client’s risk tolerance. The investments may include stocks, bonds, real estate, commodities, alternative investments, and mutual funds, among the better-known choices.

The asset manager is expected to conduct rigorous research using both macro and microanalytical tools. This includes statistical analysis of prevailing market trends, reviews of corporate financial documents, and anything else that would aid in achieving the stated goal of client asset appreciation.

Types of Asset Managers

There are several different types of asset managers, distinguished by the type of asset and level of service that they provide. Each type of asset manager has a different level of responsibility to the client, so it is important to understand a manager’s obligations before deciding to invest.

Registered Investment Advisers

A registered investment adviser (RIA) is a firm that advises clients on securities trades or even manages their portfolios. RIAs are closely regulated and are required to register with the SEC if they manage more than $100 million in assets.

Investment Broker

A broker is an individual or firm that acts as an intermediary for their clients, buying stocks and securities and providing custody over customer assets. Brokers generally do not have a fiduciary duty to their clients, so it is always important to thoroughly research before buying.

Financial Advisor

A financial advisor is a professional who can recommend investments to their clients, or buy and sell securities on their behalf. Financial advisors may or may not have a fiduciary duty to their clients, so it is always important to ask first. Many financial advisors specialize in a specific area, such as tax law or estate planning.

Robo-Advisor

The most affordable type of investment manager isn’t a person at all. A robo-advisor is a computer algorithm that automatically monitors and rebalances an investor’s portfolio according, selling and buying investments according to programmed goals and risk tolerances. Because there is no person involved, robo-advisors cost much less than a personalized investment service.

How Much Does Asset Management Cost?

Asset managers have a variety of fee structures. The most common model charges a percentage of the assets under management, with the industry average at about 1% for up to $1 million, and lower for larger portfolios. Others may charge a fee for each trade they execute. Some may even receive a commission to upsell securities to their clients.

Because these incentives can work against the client’s interests, it is important to know if your management firm has a fiduciary duty to serve the client’s interests. Otherwise, they may recommend investments or trades that do not serve the client’s interests.

How Asset Management Companies Work

Asset management companies compete to serve the investment needs of high-net-worth individuals and institutions.

Accounts held by financial institutions often include check-writing privileges, credit cards, debit cards, margin loans, and brokerage services.

When individuals deposit money into their accounts, it is typically placed into a money market fund that offers a greater return than a regular savings account. Account-holders can choose between Federal Deposit Insurance Company-backed (FDIC) funds and non-FDIC funds.

The added benefit to account holders is all of their banking and investing needs can be met by the same institution.

These types of accounts have only been possible since the passage of the Gramm-Leach-Bliley Act in 1999, which replaced the Glass-Steagall Act. The Glass-Steagall Act of 1933, passed during the Great Depression, forced a separation between banking and investing services. Now, they have only to maintain a “Chinese wall” between divisions.

Example of an Asset Management Institution

Merrill Lynch offers a Cash Management Account (CMA) to fulfill the needs of clients who wish to pursue banking and investment options with one vehicle, under one roof.

The account gives investors access to a personal financial advisor. This advisor offers advice and a range of investment options that include initial public offerings (IPO) in which Merrill Lynch may participate, as well as foreign currency transactions.

Interest rates for cash deposits are tiered. Deposit accounts can be linked together so that all eligible funds aggregate to receive the appropriate rate. Securities held in the account fall under the protective umbrella of the Securities Investor Protection Corporation (SIPC). SIPC does not shield investor assets from inherent risk but rather protects those assets from the financial failure of the brokerage firm itself.

Along with typical check writing services, the account offers worldwide access to Bank of America automated teller machines (ATM) without transaction fees. Bill payment services, fund transfers, and wire transfers are available. The MyMerrill app allows users to access the account and perform a number of basic functions via a mobile device.

Accounts with more than $250,000 in eligible assets sidestep both the annual $125 fee and the $25 assessment applied to each sub-account held.

Frequently Asked Questions

The Bottom Line

Asset management firms provide the service of buying and selling assets on behalf of their clients. There are many types of asset managers, with some working for family offices and wealthy individuals and others working on behalf of major banks and institutional investors.

What Are Affiliated Companies?

Companies are affiliated when one company is a minority shareholder of another. In most cases, the parent company will own less than a 50% interest in its affiliated company. Two companies may also be affiliated if they are controlled by a separate third party. In the business world, affiliated companies are often simply called affiliates.

The term is sometimes used to refer to companies that are related to each other in some way. For example, Bank of America has many different affiliated companies including Bank of America, U.S. Trust, Landsafe, Balboa, and Merrill Lynch.

Companies may be affiliated with one another to get into a new market, to maintain separate brand identities, to raise capital without affecting the parent or other companies, and to save on taxes. In most cases, affiliates are associates or associated companies, which describes an organization whose parent has a minority stake in it.

Understanding Affiliated Companies

There are several ways companies can become affiliated. A company may decide to buy out or take over another one, or it may decide to spin off a portion of its operations into a new affiliate altogether. In either case, the parent company generally keeps its operations separate from its affiliates. Since the parent company has a minority ownership, its liability is limited, and the two companies keep separate management teams.

Affiliates are a common way for parent businesses to enter foreign markets while keeping a minority interest in a business. This is especially important if the parent wants to shake off its majority stake in the affiliate.

There is no single bright-line test to determine if one company is affiliated with another. In fact, the criteria for affiliation changes from country to country, state to state, and even between regulatory bodies. For instance, companies considered affiliates by the Internal Revenue Service (IRS) may not be considered affiliated by the Securities and Exchange Commission (SEC).

Affiliates Versus Subsidiaries

An affiliate is different from a subsidiary, of which the parent owns more than 50%. In a subsidiary, the parent is a majority shareholder, which gives the parent company’s management and shareholders voting rights. Subsidiary financials may also appear on the parent company’s financial sheets.

But subsidiaries remain separate legal entities from their parents, meaning they are liable for their own taxes, liabilities, and governance. They are also responsible for following the laws and regulations where they are headquartered, especially if they operate in a different jurisdiction from the parent company.

An example of a subsidiary is the relationship between the Walt Disney Corporation and sports network ESPN. Disney owns an 80% interest in ESPN, making it a majority shareholder. ESPN is its subsidiary.

SEC Rules Surrounding Affiliates

Securities markets around the world have rules that concern affiliates of the businesses they regulate. Here again, these are complex rules that need to be analyzed by local experts on a case-by-case basis. Examples of rules enforced by the SEC include:

• Rule 102 of Regulation M prohibits issuers, selling security holders, and their affiliated purchasers from bidding for, purchasing, or attempting to induce any person to bid for or purchase, any security which is the subject of a distribution until after an applicable restricted period has passed.
• Before disclosing nonpublic personal information about a consumer to a nonaffiliated third party, a broker-dealer must first give a consumer an opt-out notice and a reasonable opportunity to opt out of the disclosure.
• Broker-dealers must maintain and preserve certain information regarding those affiliates, subsidiaries, and holding companies whose business activities are reasonably likely to have a material impact on their own finances and operations.

Tax Consequences of Affiliates

In nearly all jurisdictions, there are important tax consequences for affiliated companies. In general, tax credits and deductions are limited to one affiliate in a group, or a ceiling is imposed on the tax benefits that affiliates may reap under certain programs.

Determining whether companies in a group are affiliates, subsidiaries, or associates is done through a case-by-case analysis by local tax experts.