## Asset coverage ratio

##### Published: Nov 2012

Companies use the asset coverage ratio to measure their ability to cover their debt. When a company has a high ratio this indicates that the company is likely to be able to keep operating with current debt and asset levels, whereas a low ratio – for example see below – makes this less likely.

### How is it calculated?

$$\mathrm{Asset\:coverage\:ratio}=\frac{Total \: tangible\:assets\:\: – \:\:current\:\: liabilities\:\: – \:\:short\:term\:debt\:obligations}{Total \:debt\:outstanding}$$
Tangible assets are defined as physical or financial assets. The calculation does not include intangible assets like patents, brands and goodwill, which are more subjective and difficult to value.

### Examples

The asset coverage ratios of companies in different industries cannot always be compared because typical debt and asset levels vary between industries. A ratio considered safe for a utilities company, for example, may not be viewed so positively for, say, investment firms. As a rule of thumb, utilities should have an asset coverage ratio of at least 1.5, and industrial companies should have a ratio of at least two.

As companies UVW and XYZ are operating in the same industry, their asset coverage ratios can be compared. Company UVW is clearly in a better position than company XYZ, with higher debt-to-asset levels, and there is a higher risk that company XYZ will be unable to fulfil its obligations to creditors.

### Points to consider

This calculation includes tangible assets only – therefore the asset coverage ratio given is likely to be an underestimate, rather than an overestimate. Although intangible assets have value, it is difficult to measure these accurately and could therefore result in an overly optimistic representation of the firm’s health.

It is important, likewise, to account for depreciation of assets. If assets are sold, their current value is realised, rather than their original cost – their ‘book value’. As a result, if their book value is used in the calculation a falsely high ratio will be obtained.

As mentioned above, the ratio should be compared with other companies in the same industry if a meaningful comparison is to be drawn.

In any case, the ratio only gives one indication of a company’s health. In order to have a clearer picture of a company’s financial strengths and weaknesses it should be used in conjunction with other financial ratios.