Asset coverage ratio
|Asset coverage ratio|
|Methods and techniques|
Asset coverage ratio determines a company's ability to cover debt obligations with its assets after all liabilities have been satisfied. Asset coverage ratio is important if the company wants to increase its debt (e.g. get loan). The bank will check asset coverage ratio first to test whether the company is able to pay its debts.
Three types of asset coverage ratios
Coverage ratio presents whether a company is able to pay its debts. The higher the coverage ratio, the better. The most information analysts can get from analysis of trends of coverage ratio over time. There are three main coverage ratios:
- ICR - interest coverage ratio shows ability's company to pay interest,
- DSCR - debt service coverage ratio - describes whether company is able to pay all the debts,
- ACR - asset coverage ratio, describe whether your company is able to pay all the debts with your assets.
Asset coverage ratios
Aset coverage ratio (ACR) – allows you to see how much of the company's assets will have to be sold to cover unpaid debts. Asset coverage ratio is calculated by dividing material and cash assets by the sum of fiscal liabilities .
The formula is:
- ACR - Asset Coverage Ratio
- Current Liabilities - total trade payables and other payables that are payable within 12 months.
- Short-term Debt - with a maturity below 1 year, consists of short-term bank loans or commercial paper.
Interpretation of asset coverage ratios
Depending on the scale and type of business and industry, asset coverage ratio can take different values. Industrial enterprises should have this indicator at the level of 1.5 - 2 . Lenders, for example, when making a loan agreement, set acceptable asset coverage ratio thresholds. The value of the asset coverage ratio range then depends on the credit policy or the level of risk and the market situation accepted by the lender. The higher the asset coverage ratio indicator, the more likely it is to repay total debt, better secure the loan agreement and lower the risk associated with the investment.
The Total asset book value may cause an overvaluation of the asset coverage ratio. This is due to the fact that the real liquidation value of assets may differ from the book value. Therefore, often lenders or investors as well as managers count the asset coverage ratio as the ratio of the market value of assets to the total amount of debt. What causes changes in the value of this indicator in line with demand and supply on the asset market .
Usage of asset coverage ratio
Asset coverage ratio is used to assess the risk of insolvency. A low asset coverage ratio can warn managers and investors about over-indebtedness.
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- Gavalas D., Syriopoulos T., 2013, p. 70
- Gavalas D., Syriopoulos T., 2013, p. 71
- Kavussanos M. G., Tsouknidis D. A., 2016, p. 17
Author: Justyna Banowska