Asset Coverage Ratio
The asset coverage ratio is used to measure the ability of the company to repay its debt obligation by selling its assets. From this ratio, investors know how much assets require to pay down the firm’s debt obligation. Debt, equity, and retained earning are three sources of a company’s capital.
Owner of firms or companies is called the equity investors. So if the company is not a profitable company then equity investor does not gain on its investment.
But it is essential to pay the debt investors on regular interval no matter the financial condition of the company is good or not.
If the financial status of the company is not good and it will not be able to pay the investors then management force the company to sell its assets.
Then both debt and equity investors get the total assets coverage ratio to find the worth of the assets vs the debt obligation of the company.
For the financial stability, capital management, and for the all risks of the company measuring analysts use this ratio.
If the ratio is high then it is good for the investor to invest in this company but if the ratio is low then it is not good. the company needs to maximize the quality of assets to maintain high assets coverage ratio.
Asset Coverage Ratio Formula
Through Asset Coverage Ratio Formula when we subtract the difference of current liabilities, and short term debt from the difference of total asset, and intangible asset and then dividing by total debt then we get the asset coverage ratio that is:
((total asset-intangible asset)-(current liabilities-short term portion of LT debt))/total debt= asset coverage ratio
1) From the annual report of any company from the balance sheet, you can put values in this formula to get an asset coverage ratio.
2) Intangible Asset: the sum of the tangible and intangible asset is called total assets that’s why we remove intangible from the total asset in formula
3) All the liabilities added and then subtract from the short term debt which is due less then 1 year.
When we subtract the result of point a from the result of point b then divided it by the total debt then we get the total asset coverage ratio.
Asset Coverage Ratio Example
Now we give the example of the company whose financial data available in the below table. From the table, we can see that the assets of the company increase greatly as compared to debt it means that in 3 years the asset coverage ratio increase.
Analysis and interpretation
When the asset coverage ratio is greater then 1 then it is generally a good sign. But the asset coverage ratio for different companies vary. for example, if we take the coverage asset ratio of utility company 1.0 – 1.5x then it considers good and when we take this ratio for capital goods company then 1.0 -2,0x consider as a normal ratio.
Ratio mostly uses to give the theoretical data which not the same as the real world. but from the business standpoint, it is interpreted. there are many factors which are underlying and understanding by the analyst which spend very much time for the resulting number.
in the particular country, low coverage ratio will be accepted by the lender because from its result analyst execute the result of the strategy of the corporate.
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