The asset coverage ratio provides an approximate measure of the ability of an organization to pay its debts. The ratio is used by outside analysts when conducting an examination of the finances of a business. Though expressed as a ratio, it really requires a set of formulation steps, which are as follows:
- Extract from the general ledger the ending balances of all assets.
- Subtract from the total of these assets the amounts recorded on the books for any intangible assets. This deduction is made on the assumption that intangible assets cannot be converted into cash; if this is not the case, retain those intangibles that have a conversion value.
- Extract from the general ledger all current liabilities, not including those liabilities associated with short-term debt.
- Subtract the net liabilities figure in step 3 from the net asset figure derived in step 2. The result should be the amount of assets available for use to pay down debts.
- Divide the net amount derived in step 4 by the ending book balance of all debt outstanding. This includes the amount of any capital leases outstanding.
The result of this ratio can be difficult to interpret, for there is a potentially incorrect assumption built into it that the assets listed in the numerator can be readily converted into the same amount of cash. The assumption could be wrong for the following reasons:
- If the asset conversion is required in a rush, the amount of cash that may be obtained could be substantially lower.
- The assets are stated at their book values, which may not equate to their market values.
- Certain accounts receivable and inventory items may not be collectible at all, so if these items comprise a large proportion of the asset balance, the amount of available cash could be much lower than indicated by the ratio.
Given these concerns, do not rely on the asset coverage ratio unless the ratio is quite high - the net asset amount should be at least 2x higher than the debt amount. Better yet, deduct the most illiquid assets from the numerator to gain a better feel for the true liquidity of the organization.