What it means
The calculation starts from total assets and strips out whatever a lender cannot rely on. Intangible assets such as goodwill and brand values are removed because they rarely fetch much in a forced sale, and current liabilities other than short-term debt are deducted because trade creditors, wages and tax rank ahead in a wind-up.
What is left is compared with total debt. Lenders care because it answers a different question from an interest cover or cash flow test.
A company can be profitable today and still offer thin security, while a loss-making business with heavy property holdings can be comfortably covered. Bond covenants, bank facilities and the rules governing some investment companies therefore set a minimum coverage that must be maintained throughout the life of the debt.
Reading the result takes context. Coverage above about 2 times is generally considered comfortable for an asset-heavy business, whereas a services firm whose value sits in people and contracts may never reach 1 time and has to borrow against cash flow instead.
Trend matters as much as level, because coverage falling steadily over three years points to rising debt or deteriorating asset quality. The main weakness is that the ratio leans on book values.
Property carried at historic cost may be worth far more than the accounts show, specialised plant may be worth far less, and inventory and receivables in a distressed sale often realise only a fraction of their carrying amount. Careful analysts apply a haircut to each category before they trust the number.
Variants exist, so the definition in the document always wins. Some lenders measure coverage against senior debt only, some include lease liabilities within total debt, and certain regulated investment vehicles follow a prescribed statutory calculation.
Two parties can produce very different ratios from the same accounts simply by applying different definitions.
In practice
Real-world examples.
Example
A haulage company has total assets of $6,000,000, goodwill of $400,000, current liabilities of $1,000,000 of which $200,000 is an overdraft, and total debt of $2,000,000. Its coverage is ($6,000,000 - $400,000 - $800,000) / $2,000,000 = 2.4 times, comfortably above the 1.75 times required by its loan agreement. The bank agrees to finance two more vehicles on the strength of it.
Example
A software firm applies for a $2,000,000 facility, but its balance sheet is mostly capitalised development costs and goodwill. Stripping out intangibles leaves tangible assets of only $300,000 against the proposed debt, so coverage would be well below 0.2 times. The lender switches to a cash flow test supported by a personal guarantee instead.
Example
A property investment company issues bonds with a covenant requiring coverage of at least 2 times. After a valuation writedown, coverage falls to 1.8 times and the company must either repay debt or inject equity. The directors choose a $10,000,000 equity raise to restore the ratio and keep the bonds in good standing.
Formula
Calculation
Asset coverage ratio = (Total assets - Intangible assets - Current liabilities excluding short-term debt) / Total debt
A company reports total assets of $1,200,000, including goodwill of $200,000. Current liabilities are $300,000, of which $100,000 is a bank overdraft classed as short-term debt, leaving $200,000 of other current liabilities. Long-term debt is $300,000.
Total debt = $100,000 + $300,000 = $400,000
Adjusted assets = $1,200,000 - $200,000 - $200,000 = $800,000
Asset coverage ratio = $800,000 / $400,000 = 2.0 times
If the loan agreement sets a minimum of 1.5 times, the covenant breaks once adjusted assets fall to $600,000, because $600,000 / $400,000 = 1.5 times. The company therefore has $200,000 of headroom in tangible asset value before it has a problem.Case study
Seen in the real world.
Imagine Fenwick Cold Storage, a fictional operator of refrigerated warehouses used here only as an illustrative case. It had borrowed $12,000,000 against property and plant, with adjusted tangible assets of $30,000,000, giving coverage of 2.5 times against a covenant minimum of 1.75 times.
Over the next two years the illustrative company bought a smaller rival largely for its customer list, adding $6,000,000 of goodwill, and funded the purchase with $6,000,000 of new debt. Because goodwill is excluded from the calculation, adjusted assets stayed near $30,000,000 while debt rose to $18,000,000, so coverage fell to about 1.67 times and the covenant was breached even though profit had grown.
Fenwick negotiated a waiver, then sold one warehouse and used the proceeds to repay $4,000,000 of debt. That left adjusted assets of roughly $26,000,000 against debt of $14,000,000, restoring coverage to about 1.86 times. Its fictional finance director now models the ratio before agreeing any acquisition priced largely on goodwill.
Watch out
Common mistakes.
- Leaving goodwill and other intangibles in the calculation, which flatters coverage for any business built by acquisition.
- Using the ratio to judge the ability to pay interest, when interest cover and cash flow tests answer that question.
- Trusting book values in a distress scenario without applying a haircut to inventory, receivables and specialised plant.
Questions
People also ask.
What counts as a good asset coverage ratio?
It depends on the industry and the covenant, but 2 times or better is generally seen as comfortable for an asset-heavy business, while asset-light firms are assessed on cash flow instead.
Does asset coverage include lease liabilities?
It depends entirely on the definition in the facility agreement, and many modern documents do include them in total debt, so the wording should be checked before calculating.
How does it differ from the debt to equity ratio?
Debt to equity compares the sources of funding on the balance sheet, while asset coverage asks how much tangible value sits behind the debt once prior claims are settled.
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