Asset Coverage Ratio - Explained
What is the Asset Coverage Ratio?
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Table of ContentsWhat is Asset Coverage Ratio?How is the Asset Coverage Ratio Used?Asset Coverage Ratio CalculationAcademic Research on Asset Coverage Ratio
What is Asset Coverage Ratio?
The ability of a firm to meet all its financial obligations after all debts have been paid is crucial to the survival of such a firm. There are many ratios that measure the financial strength or solvency of companies, the asset coverage ratio is one. The asset coverage ratio is a test that measures the ability of a company to meet financial obligations after all liabilities have been resolved. This ratio also determines whether a company can cover its level of debt with its assets. That is if assets owned by the company are sold, are they sufficient to pay up the company's liability.
Back to: ACCOUNTING, TAX, & REPORTING
How is the Asset Coverage Ratio Used?
Companies require capital to run their operations, there are two major ways to generate capital for a firm, one is through debt financing and the other is through equity. Equity and debt differ in the sense that debt must be repaid to third-party lenders while equity is not repaid. The asset coverage ratio tells lenders, banks or other financial institutions whether the assets of a firm can cover its debts in a situation where the earnings of the firm cannot cover its obligations. Ordinarily, when a company's earnings are insufficient to pay back debts, such company resorts to selling is assets to generate funds m this ratio measure the financial strength of companies in this event.
There are different forms of ratios that lenders and financial institutions use to measure the financial solvency of a company. The asset coverage ratio is a commonly used ratio that determines whether a company's assets are sufficient to cover its debts and liabilities in cases when the company's earnings falter. A high asset coverage ratio indicates that a company is able to cover its debts with its assets while a low asset coverage ratio indicates otherwise.
Asset Coverage Ratio Calculation
A company with a high asset coverage ratio is considered less risky than a company with a low asset coverage ratio. To calculate this ratio, the formula below is applicable; ((Assets Intangible Assets) (Current Liabilities Short-term Debt)) / Total Debt All the information needed for the calculation of the asset coverage ratio can be found on a company's balance sheet such as current liabilities, intangible assets, assets, and all others.
Academic Research on Asset Coverage Ratio
- Corporate Governance in Listed Italian Family Firms: Impact on Performance and Comparison with Non-Family Firms., Culasso, F., Broccardo, L., Mazzoleni, A., & Giacosa, E. (2012). Corporate Governance in Listed Italian Family Firms: Impact on Performance and Comparison with Non-Family Firms.Journal of Management & Change,29(1). The main goal of this study is to analyse the impact of board composition on performance within listed Italian firms, comparing this impact between family and non-family firms. This variable has a significant impact on business performance. Indeed, many studies underline the importance of board composition through the composition-performance relationship, and whether this relationship considers financial indicators alone in order to measure performance. The research method is the analysis of a sample composed of listed Italian family and non-family firms (FTSE MIB and STAR) and the data used were taken from the AIDA database and the 'Borsa Italiana' website, which is the Italian website containing the official data of listed companies. Family firms considered for the purposes of this study were chosen following two criteria: first, the family controls a relevant percentage of the ownership and, second, at least one family member has a management role and participates in the board. This study contributes to the literature on family corporate governance and shows that family involvement has a positive effect on company performance. Further research will aim to eliminate the limitations of our study. In particular, we would like to increase the number of companies in the sample, considering all the listed companies on the Italian stock market and the non-listed ones; it could also be interesting to compare Italian listed companies with non-Italian ones.
- Predictive power of financial risk factors: an empirical analysis of default companies, Jayadev, M. (2006). Predictive power of financial risk factors: an empirical analysis of default companies.Vikalpa,31(3), 45-56. This paper provides empirical evidence on the significance of financial risk factors in predicting default companies. Traditionally, credit decision process is built on accounting ratios derived from financial statements of the borrower. Combining various ratios through application of multivariate statistical techniques and testing their predictive power has been popular in credit risk quantification. Altman's Z-score model is the most acceptable model in this category.
- How should we measure bank capital adequacy for triggering Prompt Corrective Action? A (simple) proposal, Chernykh, L., & Cole, R. A. (2015). How should we measure bank capital adequacy for triggering Prompt Corrective Action? A (simple) proposal.Journal of Financial Stability,20, 131-143. In this study, we test the predictive power of several alternative measures of bank capital adequacy in identifying U.S. bank failures during the recent crisis period. We find that an unconventional ratio the non-performing asset coverage ratio (NPACR) significantly outperforms Basel-based ratios including the Tier 1 ratio, the Total Capital Ratio, and the Leverage ratio throughout the crisis period. It also outperforms in predicting failures among well-capitalized banks (as defined by the current Prompt Corrective Action guidelines). Based on our results, we argue that NPACR outperforms other ratios in at least five aspects: (i) it aligns capital and credit risks the two primary risks of bank failures in one measure; (ii) it is easier to calculate than the Tier 1 and Total Capital ratios, as it requires calculation of no complex risk weights; (iii) it allows one to account for various time period and cross-country provisioning rules and regimes, including episodes of regulatory forbearance and cross-country differences; (iv) it removes the incentives of both banks and regulators to mask capital deficiencies by creating/requiring insufficient loan-loss reserves; and (v) it outperforms all other commonly used capital ratios in predicting bank failures. We believe that all the above features of proposed measure promise its effective use in the prompt corrective actions by bank regulators. We also expect that this single and informative measure of bank risk can be efficiently used in empirical banking studies. The results of this study also shed light on regulatory forbearance during the recent banking crisis.
- The Regulation of Mutual Fund Debt, Morley, J. (2013). The Regulation of Mutual Fund Debt.Yale J. on Reg.,30, 343.
- Use of Binary Dependent Variables for Modelling Borrowers' Creditworthiness, Kadochnikova, E. I., Polovkina, E. A., Grigoreva, E. A., & Badrieva, L. D. (2015). Use of Binary Dependent Variables for Modelling Borrowers' Creditworthiness.Asian Social Science,11(11), 396.
- Financial performance analysis and bankruptcy prediction in hungarian dairy sector, Andrea, R. (2014). Financial performance analysis and bankruptcy prediction in hungarian dairy sector.The Annals of the University of Oradea. Economic Sciences,23, 936-45. Today, the intellectual property protection is no longer an absolute social and legal that justifies adoption of any measures necessary to protect it. Initially seen as the prerequisite for sustainable development, implementation of new technologies, and encouragement of international trade, the intellectual property, especially prior to ACTA (Anti-Counterfeiting Trade Agreement) international trial implementation, and also thereafter, was increasingly identified as a source of violation of fundamental rights and civil liberties, i.e. the right to protection of personal data, the right to privacy, freedom to send and receive information freedom of information, freedom to contract, and freedom to carry out economic activities (freedom of commerce). As far as international trade transactions have often a component of intellectual property that requires to be protected, it is necessary to identify the landmarks, the rules establishing de facto limits in order to protect the intellectual property without risk of infringement of fundamental rights and civil liberties of other persons, in particular users or potential users of goods and services incorporating intellectual property. The best guidelines in this regard may be provided by the CJEU (Court of Justice of the European Union) case-law both due to its reasoning underlying the decision of the Parliament to reject ACTA ratification and the fact that the case-law of this Court, especially the most recent one, is highly complex and nuanced, not denying in any way the importance of intellectual property, and identifying certain cases where their primacy persist and whose analysis leads to laying down some general rules in the field.