The asset coverage ratio (ACR) is a crucial tool for understanding a company’s financial health, particularly its ability to pay short-term and long-term debt. It is a financial metric used primarily by creditors and lenders to assess the ability of a company to cover its debts by comparing total assets after current liabilities to the total amount of debt outstanding. It’s particularly important for companies with significant debt obligations, such as those that have loans outstanding.
Key takeaways
- ACR is a valuable metric for investors, creditors, and analysts to evaluate investment risk, creditworthiness, and overall financial health.
- Generally, a higher ACR indicates a stronger ability to meet debt obligations while a lower ratio might raise concerns about potential financial risk.
- ACR relies on the book value of assets, which may not reflect actual market value, and has industry-specific ideal ratios.
- ACR is most effective when used in conjunction with other financial ratios and compared to historical performance and industry benchmarks for a comprehensive analysis.
How To Calculate the Asset Coverage Ratio
Here’s the formula for how to calculate the ACR:
| Asset Coverage Ratio | = | (Total Assets – Intangible Assets) – (Current Liabilities – Short Term Debt) Total Debt |
Definitions:
- Total assets: This represents the total value of all the company’s assets, including tangible assets, such as property or machinery, and intangible assets, such as patents or goodwill.
- Intangible assets: Since intangible assets are often difficult to value and sell quickly, they are excluded from the calculation.
- Current liabilities: These are short-term financial obligations that are due within one year and include short-term debt as well as other current liabilities, such as accounts payable (A/P) and accrued expenses.
- Short-term debt: This is a portion of the total debt that is due within one year. It is subtracted from total current liabilities to arrive at the portion of current liabilities representing A/P, accrued expenses, and similar nondebt current liabilities.
- Total debt: This represents the total amount of all the company’s outstanding debts, including both short-term and long-term debt, but not other current liabilities, such as accrued expenses and A/P.
The numerator in the ACR is the book value of all tangible assets remaining after paying all current liabilities other than short-term debt. The denominator is the total short-term and long-term debt but doesn’t include other current liabilities subtracted from total assets in the numerator.
By dividing the assets available after paying current liabilities (numerator) by the amount of debt (denominator), you arrive at how many times the debt could be paid with the current level of company assets.
Asset Coverage Ratio Example
Let’s say that we’re analyzing the data of ABC Company and want to calculate its ACR.
First, gather the data. We need the following information from ABC Company’s balance sheet:
Cash | 250,000 | A/P | 75,000 |
Investments | 300,000 | Accrued Expenses | 225,000 |
Net Fixed Assets | 550,000 | S/T Note Payable | 200,000 |
Intangible Assets | 100,000 | Total Current Liabilities | 500,000 |
L/T Note Payable | 500,000 | ||
Total Liabilities | 1 million | ||
Owner’s Equity | 200,000 | ||
Total Assets | 1.2 million | Liabilities + Owner’s Equity | 1.2 million |
- Total assets: $1.2 million
- Intangible assets: $100,000
- Total current liabilities: $500,000
- Short-term debt: $200,000
- Total debt: $700,000 (short-term and long-term)
Next, plug the values into the formula:
ACR = [($1.2 million – $100,000) – ($500,000 – $200,000)] ÷ $700,000
= ($1.1 million – $300,000) ÷ $700,000
= $800,000 / $700,000
= 1.143
How To Interpret the Asset Coverage Ratio
In the above example, ABC Company has an ACR of 1.143, which is barely more than 1. This indicates that the company’s total tangible assets can barely cover its total debts or notes payable.
Generally, a higher ACR indicates a better ability to repay debt. A lower ACR suggests a potentially higher risk of defaulting on debt. This could be a cause for concern, especially if the ratio is significantly below 1. However, a low ratio doesn’t necessarily mean that the company is in financial trouble.
Several factors can influence a company’s ideal ACR, such as:
- Company size and maturity: Larger, more established companies might tolerate a lower ratio than smaller, high-growth companies.
- Financial performance: Companies with strong profitability and cash flow generation can typically support a lower ACR compared to companies struggling financially.
- Debt structure: Companies with a higher proportion of long-term debt may have more flexibility than those heavily reliant on short-term debt, potentially allowing for a lower ACR.
- Fair market value (FMV) vs book value of assets: The ACR assumes that the book value of assets is a good measure of the company’s ability to pay off debt. However, this isn’t true for companies with substantial amounts of fixed assets with book values far below their actual FMV.
Asset Coverage Ratio Benchmarks
It’s important to understand that there is no single “good” ACR that applies universally across all industries. This is because different industries have varying levels of inherent risk, asset types, and debt structures.
Here are some general industry benchmarks for ACRs but, remember, these are just starting points:
- Utilities: Because of their relatively stable cash flows and high asset values (for example, power plants and infrastructure), a ratio of 1.5 or higher is often considered acceptable.
- Consumer staples: These companies typically have predictable demand and strong cash flows, so a ratio of 1.25 or higher might be considered good.
- Financials: Banks and other financial institutions often have a higher risk profile and rely more heavily on debt financing. As a result, a ratio of 1.0 or higher might be considered acceptable in this industry.
- Industrials: This sector encompasses a broad range of companies, and the ideal ratio can vary depending on the specific sub-industry. However, a general benchmark might be a ratio of 1.5 or higher.
- Technology: Tech companies often have high intangible assets (for example, intellectual property) and can be more reliant on debt to finance growth. Therefore, a ratio of 1.0 or higher might be acceptable in this industry.
Asset Coverage Ratio Considerations
Generally, a higher ACR indicates a better ability to repay short-term debt. However, for a more comprehensive understanding, it’s crucial to consider industry benchmarks and compare the ratio over time.
Here are some additional points to consider:
- The ACR is just one piece of the puzzle and should be used alongside other financial ratios for a more complete picture of a company’s financial health.
- The book value of assets on the balance sheet might not reflect their actual market value, potentially impacting the accuracy of the ACR.
- Analyzing the ACR over time can be more informative than just looking at a single point in time. A declining ratio could indicate potential financial stress, while a rising ratio could suggest the company is becoming more financially stable.
What Are Assets & Liabilities?
Assets and liabilities are two fundamental components of a company’s financial position:
- Assets are resources owned or controlled by an organization that have economic value and can generate future benefits.
- Liabilities are financial obligations or debts owed to external parties. They arise from past transactions or events.
Understanding and effectively managing both assets and liabilities are crucial for financial stability and success.
In accounting, an asset is any resource with economic value that an individual, corporation, or country owns or controls with the expectation that it will provide a future benefit. This benefit can take many forms, such as generating cash flow, reducing expenses, or improving sales.
Here are some key points about assets:
- Types of assets: They can be tangible (physical objects like machinery, buildings, or inventory) or intangible (non-physical things like copyrights, patents, or brand names).
- Classification: Assets are typically categorized into different groups based on their liquidity, or how easily they can be converted into cash, and their use in the business (operating or non-operating). Common classifications include current assets, fixed assets, financial assets, or intangible assets.
- Financial statements: Assets are reported on a company’s balance sheet, which provides a snapshot of its financial position at a specific point in time. They are listed alongside liabilities (what the company owes) and shareholder equity (the difference between assets and liabilities, representing the owner’s investment in the company).
Liabilities are financial obligations that a business owes to others. Understanding a company’s liabilities is crucial for assessing its financial health and solvency.
These obligations can arise from various sources, such as:
- Borrowed money: This includes loans, bonds, and other forms of debt.
- A/P: Accounts payable includes amounts owed to suppliers for goods or services purchased on credit.
- Salaries and wages payable: These are amounts owed to employees for their work.
- Taxes payable: Taxes payable includes amounts owed to the government in taxes.
Frequently Asked Questions (FAQs)
There’s no single “good” ratio applicable to all industries. Ideal ratios can vary depending on factors like the type of industry, company size and maturity, and financial performance.
Use the asset coverage ratio in conjunction with other financial ratios like the current ratio and quick ratio. Compare the ratio to the company’s historical performance and industry benchmarks. And consider the company’s overall financial health through other metrics and seek guidance from financial professionals for deeper insights.
The asset coverage ratio is a valuable tool for gaining insights into a company’s ability to manage its short-term debt obligations and overall financial health, especially when used in conjunction with other financial analysis methods. The ratio also helps investors assess the investment risk associated with a company by understanding its ability to manage its short-term debts. Creditors use it to evaluate the company’s creditworthiness before making lending decisions.
The asset coverage ratio relies on the book value of assets, which might not reflect their actual market value in case of liquidation. It also doesn’t consider future cash flows or the company’s ability to generate additional funds.
Bottom Line
The asset coverage ratio provides valuable insights into a company’s ability to handle its short-term debt obligations. While not a standalone measure, it offers a starting point for assessing financial risk and comparing companies within the same industry. By understanding its limitations and leveraging it effectively, the ACR can be a powerful tool for investors, creditors, and analysts in navigating the financial landscape.
