Asset Coverage Ratio: Definition, Calculation, and Example

What Is the Asset Coverage Ratio?

The asset coverage ratio is a key financial metric that measures how well a company can repay its debts by selling or liquidating its assets. It’s important because it helps lenders, investors, and analysts measure a company’s financial solvency and risk profile. A higher asset coverage ratio generally indicates that the company has more than enough assets to cover its debt, making it less risky to lenders; a lower ratio suggests that it may face difficulty paying its debt. Banks and creditors often consider a minimum asset coverage ratio before lending money.

Understanding the Asset Coverage Ratio

The asset coverage ratio allows creditors and investors to gauge the level of risk associated with investing in a company. Once the coverage ratio is calculated, it can be compared to the ratios of companies within the same industry or sector, helping to determine whether a company carries a manageable debt level compared to its peers.

It’s important to note that the ratio is less reliable when compared to companies in different industries. Companies within certain industries may typically carry more debt on their balance sheets than those in other industries.

For example, companies in the tech sector, like Microsoft and Meta, generally operate with relatively low debt levels compared to their market capitalization, due to the nature of their business. In contrast, companies in capital-intensive industries, such as ExxonMobil in the oil and gas industry, often carry higher debt levels to finance expensive equipment like oil rigs. Exxon ended the second quarter of 2024 with $36.57 billion in long-term debt. Despite these higher debt levels, ExxonMobil’s substantial assets allow it to maintain a healthy asset coverage ratio.

Asset Coverage Ratio Calculation

The asset coverage ratio is calculated with the following equation:

$begin{aligned}&frac{(text{Total Assets}-text{Intangible Assets})-(text{Current Liabilities}-text{Short-term Debt})}{text{Total Debt}}end{aligned}$​Total Debt(Total Assets−Intangible Assets)−(Current Liabilities−Short-term Debt)​​

Here’s a breakdown of this formula:

• Total assets refers to all the assets a company owns.
• Intangible assets are assets that can’t be physically touched, such as goodwill, patents, or trademarks.
• Current liabilities are liabilities due within one year.
• Short-term debt is debt that is also due within one year.
• Total debt includes both short-term and long-term debt.

All of these components can be found in a company’s annual report, on its balance sheet.

How the Asset Coverage Ratio is Used

Companies that issue shares of stock or equity to raise funds don’t have a financial obligation to pay those funds back to investors. However, when companies issue debt through bonds or borrow from banks, they must make regular payments and eventually repay the principal.

As a result, banks and investors holding a company’s debt want to know whether its earnings or profits are sufficient to cover future debt obligations and what might happen if earnings fall short. 

The asset coverage ratio is a key solvency ratio that addresses this concern. It measures how well a company can cover its short-term debt obligations using its assets, especially when earnings may not suffice.

A higher asset coverage ratio indicates that a company has enough assets to cover its debts multiple times, making it less risky for lenders. 

If earnings aren’t enough to cover the company’s financial obligations, the company might be required to sell assets to generate cash. The asset coverage ratio tells creditors and investors how often the company’s assets can cover its debts if earnings are insufficient to cover debt payments.

The asset coverage ratio is more extreme than the debt service ratio, as it reflects the company’s ability to cover its debts by liquidating assets. This scenario represents a last resort, typically used only in financial distress situations.

Special Considerations

There’s one caveat to consider when interpreting the asset coverage ratio. Assets found on the balance sheet are recorded at their book value, which is often higher than the liquidation or selling value if a company needs to sell assets to repay debts. So, the asset coverage ratio may appear slightly inflated, presenting a more favorable view of a company’s ability to cover its debts than is realistic. This is why it’s important to compare the asset coverage ratio with other companies within the same industry.

Example of the Asset Coverage Ratio

Let’s say, for example, that Exxon Mobil Corporation (XOM) has an asset coverage ratio of 1.5, indicating it has 1.5 times more assets than debts. Let’s say Chevron Corporation (CVX)—within the same industry as Exxon—has a comparable ratio of 1.4.

However, if Chevron’s previous ratios were 0.8 and 1.1, the current 1.4 suggests financial improvement through increasing assets or deleveraging (paying down debt). Conversely, if Exxon’s asset coverage ratio was 2.2 and 1.8 for the prior two periods, the current 1.5 ratio could be the start of a worrisome trend of decreasing assets or increasing debt.

The Bottom Line

The asset coverage ratio is a financial metric that helps assess a company’s ability to repay its debt using its assets. A higher ratio generally indicates a lower risk to lenders, but the ideal ratio can vary depending on the industry.

While useful, this ratio has limitations and should be considered alongside other financial metrics, such as the debt-to-equity ratio and the interest coverage ratio. Also, comparing the asset coverage ratio over time and against its industry peers provides a more comprehensive view of a company’s finances.