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.]