Creditors and investors can determine the degree of risk involved with investing in a company using the asset coverage ratio. Once the coverage ratio has been determined, it may be contrasted with the ratios of other businesses operating in the same sector or industry. It’s crucial to remember that the ratio loses validity when used to compare businesses from other industries. Businesses in some industries may typically have more debt on their balance sheets than businesses in other areas.
For instance, a software firm might not have much debt, whereas an oil producer often has more debt since it needs to fund expensive equipment like oil rigs, but it also has assets on its balance sheet to serve as collateral for the loans.
The following equation is used to determine the asset coverage ratio:
Total Debt = ((Assets – Intangible Assets) – (Current Liabilities – Short-term Debt))
In this equation, “assets” stands for total assets, and “intangible assets” are intangible assets like goodwill or patents that cannot be touched. Short-term debt is debt that is due within a year, whereas current liabilities are obligations that are due immediately. Both short-term and long-term debt is referred to as “total debt.”
Businesses that issue debt through bond offerings or borrow money from banks or other financial institutions are required to make prompt payments and eventually repay the principle borrowed.
Because of this, banks and investors that hold a company’s debt want to know if its earnings or profits will be enough to pay off its debt in the future. However, they also want to know what will happen if those profits fall short. If a company has more assets than short-term debt and liabilities, it gives the lender more confidence that it will be able to repay the money it borrows in the event that earnings are insufficient to pay off the debt.