Asset coverage ratio
|Asset coverage ratio|
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.
Examples of Asset coverage ratio
- Fixed-Charge Coverage Ratio (FCCR): The Fixed-Charge Coverage Ratio (FCCR) is a measure of a company’s ability to meet its fixed financial obligations, such as interest payments, debt repayments, and lease payments. It is calculated by dividing a company’s net operating income by its total fixed charges.
- Debt Service Coverage Ratio (DSCR): The Debt Service Coverage Ratio (DSCR) is a measure of a company’s ability to cover its current debt obligations. It is calculated by dividing a company’s net operating income by its total debt service.
- Cash Flow Coverage Ratio (CFCR): The Cash Flow Coverage Ratio (CFCR) is a measure of a company’s ability to cover its current cash flow obligations. It is calculated by dividing a company’s net cash flow from operations by its total cash flow obligations.
- Cash Flow to Debt Coverage Ratio (CFDCR): The Cash Flow to Debt Coverage Ratio (CFDCR) is a measure of a company’s ability to cover its current debt obligations with its cash flow. It is calculated by dividing a company’s net cash flow from operations by its total debt payments.
Advantages of Asset coverage ratio
A high Asset Coverage Ratio has many advantages for a company. It indicates a strong financial position and a good ability to cover debt obligations. Specifically, it has the following advantages:
- It provides assurance to creditors that their investments are safe and that the company is able to meet its debt obligations.
- It allows companies to obtain additional financing from lenders by showing that the company is financially sound and that there is enough collateral to cover the debt.
- It can also help the company increase its borrowing capacity and get better loan terms.
- It helps the company maintain a good credit rating by showing that it can meet its debt obligations even in difficult times.
- It increases the confidence of investors in the company's financial strength and its ability to repay its debts.
Limitations of Asset coverage ratio
Asset coverage ratio is an important measure for assessing the ability of a company to cover its debt obligations; however, it has certain limitations:
- It does not take into account the liquidity of the assets – it only considers the value of the assets and not how quickly they can be converted into cash.
- It does not factor in the cost of selling the asset in order to pay off the debt, which could be significant.
- It does not account for the value of the company’s intangible assets, such as patents or trademarks, which can be important sources of value.
- It can be difficult to accurately value certain assets, such as real estate.
- It is not a perfect measure of a company’s financial situation, as it does not factor in liabilities or future income.
In addition to Asset Coverage Ratio, other approaches to evaluate a company's ability to cover its debt obligations are:
- Debt-to-Equity Ratio: This ratio measures a company's financial leverage by comparing its total liabilities to its total shareholders' equity. A higher ratio indicates higher financial risk.
- Interest Coverage Ratio: This ratio measures a company's ability to pay its debt obligations by comparing its operating income to its interest expenses. A higher ratio indicates better debt coverage.
- Cash Flow to Debt Ratio: This ratio measures a company's ability to pay its debts by comparing its cash flow to its total debt. A higher ratio indicates better debt coverage.
- Debt Service Coverage Ratio: This ratio measures a company's ability to pay its debt obligations by comparing its net operating income to its total debt payments. A higher ratio indicates better debt coverage.
In summary, Asset Coverage Ratio is just one of the ways to evaluate a company's ability to cover its debt obligations; other approaches include Debt-to-Equity Ratio, Interest Coverage Ratio, Cash Flow to Debt Ratio, and Debt Service Coverage Ratio.
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- Hartlage, A. W. (2012). The Basel III liquidity coverage ratio and financial stability., ‘’Michigan Law Review’’, p. 453-483.
- Kavussanos M. G., Tsouknidis D. A. (2016). Default risk drivers in shipping bank loans., Transportation Research Part E: Logistics and Transportation Review, No 94, p. 1-55.
Author: Justyna Banowska