Asset Coverage Ratio Formula & Explained

What is Asset Coverage Ratio

Asset coverage ratio is a financial ratio that compared the company’s tangible assets with the total debt. The asset coverage ratio measures the company’s ability to pay off its debt by liquidating its tangible assets. The higher the asset coverage ratio, the higher the company’s ability to cover its debt.

Normally, the shareholders and the investors use the asset coverage ratio (ACR) to get a theoretical idea of ​​how much tangible assets are worth relative to a firm’s debt, which helps the investor predict future returns, and measure the risk associated with investments. In other words, the ratio is very useful in determining how much a company is at risk of bankruptcy.

The asset coverage ratio of 1 means the company can cover its debt by liquidating its all tangible asset (tangible assets = total debt). Thus, the company with a higher asset coverage ratio is considered to be to have a higher ability to cover its debt and vice versa.

To put it simply, a company with a high asset coverage ratio is considered to be less risky than a company with a low asset coverage ratio due to the ability to repay debt.

Asset Coverage Ratio Formula & Calculation

The asset coverage ratio can be calculated by deducting the company’s tangible assets by the current liabilities without short-term debt and then dividing them by the company’s total debt, or the following asset coverage ratio formula:

ACR = [(Total assets – Intangible assets) – (Current liabilities – Short-term debt)] / Total debt

Where:

• Total assets refer to all the company’s assets.
• Tangible assets can be determined by removing the intangible assets from the total assets.
• Current liabilities are liabilities due within 1 year.
• Short-term debt is a debt due within 1 year.
• Total debt includes both short-term and long-term debt.

The reason that the asset coverage ratio is removing intangible assets out is that the intangible assets cannot be easily sold (during the liquidation process). In the same way, the short-term debt is removed because it is owed typically to suppliers with no interest payment, then it’s not considered as debt.

Let’s say the Feriors company had the following financial results last year:

• Total assets: $200,000
• Intangible assets: $40,000
• Current liabilities: $60,000
• Short-term debt: $20,000
• Long-term debt: $10,000
• Total debt: $30,000

The company’s asset coverage ratio will be:

ACR = [(200,000 – 40,000) – (60,000 – 20,000)] / 30,000 = 4

Feriors’s asset coverage ratio is 4 times. In other words, if the company is liquidated now, the company able to repay the short-term and long-term debt 4 times.

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