Asset Coverage Ratio - Explained
What is the Asset Coverage Ratio?
Written by Jason Gordon
Updated at December 3rd, 2021
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Table of Contents
What is Asset Coverage Ratio?How is the Asset Coverage Ratio Used?Asset Coverage Ratio CalculationAcademic Research on Asset Coverage RatioWhat is Asset Coverage Ratio?
The asset coverage ratio is a test that measures the ability of a company to meet financial obligations after all liabilities have been resolved. This ratio also determines whether a company can cover its level of debt with its assets. That is if assets owned by the company are sold, are they sufficient to pay up the company's liability.
There are many ratios that measure the financial strength or solvency of companies, the asset coverage ratio is one.
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How is the Asset Coverage Ratio Used?
Companies require capital to run their operations, there are two major ways to generate capital for a firm, one is through debt financing and the other is through equity. Equity and debt differ in the sense that debt must be repaid to third-party lenders while equity is not repaid. The asset coverage ratio tells lenders, banks or other financial institutions whether the assets of a firm can cover its debts in a situation where the earnings of the firm cannot cover its obligations. Ordinarily, when a company's earnings are insufficient to pay back debts, such company resorts to selling is assets to generate funds m this ratio measure the financial strength of companies in this event.
There are different forms of ratios that lenders and financial institutions use to measure the financial solvency of a company. The asset coverage ratio is a commonly used ratio that determines whether a company's assets are sufficient to cover its debts and liabilities in cases when the company's earnings falter. A high asset coverage ratio indicates that a company is able to cover its debts with its assets while a low asset coverage ratio indicates otherwise.
Asset Coverage Ratio Calculation
A company with a high asset coverage ratio is considered less risky than a company with a low asset coverage ratio. To calculate this ratio, the formula below is applicable; ((Assets Intangible Assets) (Current Liabilities Short-term Debt)) / Total Debt All the information needed for the calculation of the asset coverage ratio can be found on a company's balance sheet such as current liabilities, intangible assets, assets, and all others.