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 companies that issue debt via a bond offering or borrow capital from banks or other financial companies have an obligation to make timely payments and ultimately pay back the principal amount borrowed as a result banks and investors holding a company s debt want to know that a company s earnings or profits are sufficient to cover future debt obligations but they also want to know what happens if earnings falter in other words the asset coverage ratio is a solvency ratio it measures how well a company can cover its short term debt obligations with its assets a company that has more assets than it does short term debt and liability obligations indicates to the lender that the company has a better chance of paying back the funds it lends in the event company earnings can not cover the debt the higher the asset coverage ratio the more times a company can cover its debt therefore a company with a high asset coverage ratio is considered to be less risky than a company with a low asset coverage ratio if earnings are not 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 many times the company s assets can cover its debts in the event earnings are not enough to cover debt payments compared to debt service ratio asset coverage ratio is an extreme or last recourse ratio because the assets coverage is an extreme use of the assets value under a liquidation scenario which is not an extraordinary event special considerationsthere is one caveat to consider when interpreting the asset coverage ratio assets found on the balance sheet are held at their book value which is often higher than the liquidation or selling value in the event a company would need to sell assets to repay debts the coverage ratio may be slightly inflated this concern can be partially eliminated by comparing the ratio against other companies in the same industry example of the asset coverage ratiofor example let s say exxon mobil corporation xom has an asset coverage ratio of 1 5 meaning that there are 1 5x s more assets than debts let s say chevron corporation cvx which is within the same industry as exxon has a comparable ratio of 1 4 and even though the ratios are similar they don t tell the whole story if chevron s ratio for the prior two periods was 8 and 1 1 the 1 4 ratio in the current period shows the company has improved its balance sheet by increasing assets or deleveraging paying down debt conversely let s say exxon s asset coverage ratio was 2 2 and 1 8 for the prior two periods the 1 5 ratio in the current period could be the start of a worrisome trend of decreasing assets or increasing debt in other words it s not enough to merely analyze one period s asset coverage ratio instead it s important to determine what the trend has been over multiple periods and compare that trend with like companies 