What is Asset Coverage?
Asset coverage measures how well a company can use its assets to pay off specific debts or financial promises. You know how sometimes you borrow money from a friend and promise to repay them? And to make them feel better, you say, “Hey, if I can’t pay you back with cash, you can have my bike.”? Companies do the same thing but with more significant numbers and complicated “IOUs.”
Covering Debts and Stocks
One classic case of asset coverage is when a company issues bonds. Bonds are basically the company saying, “Lend us money now, and we’ll pay you back later with interest.” But bond buyers want to know the company is good for it. So the company might say, “We’ve got assets worth three times what we’re borrowing.” That’s asset coverage—the company is using its assets to “cover” the debt.
Another example is preferred stock. Preferred stock is a hybrid of regular stock and a bond. The company promises to pay preferred stockholders dividends before the common stockholders get a dime. Asset coverage comes into play because preferred stockholders want to know the company has enough assets to pay those dividends.
How Asset Coverage Works
The Asset Coverage Ratio
The key to asset coverage is the asset coverage ratio. This ratio compares the value of Ratiopany’s assets to the specific liability or financial claim amount.
Here’s the formula: Asset Coverage Ratio = (Total Assets – Intangible Assets) / (Specific Liability or Claim)
Intangible assets are things the company owns that you can’t physically touch, like patents or trademarks. They get taken out because they’re harder to turn into cash if the need arises.
An Asset Coverage Example
Let’s say TechCo issues $10 million in bonds. Bondholders want to see that TechCo has over $10 million in assets. So, they calculate the asset coverage ratio:
TechCo has:
- $100 million in total assets
- $20 million of that is intangible assets like patents
- $10 million in bond debt
Asset Coverage ratio = ($100 million – $20 Ratioon) / $10 million = 8
With a ratio 8, TechCo’s assets “cover” the bond debt 8 times over. That’s a cozy safety margin for the bondholders. They can feel pretty confident they’ll get paid back.
Limitations of Asset Coverage
Asset coverage ratios look at the book value of assets, which is the value of the assets according to the company’s financial statements. But if the company had to sell assets quickly to pay debts, it might not get that full book value amount.
Also, some assets are more accessible to turn into cash than others. A company could have a high asset coverage ratio but still struggle to pay debts if its assets aren’t very “liquid.”
Why Asset Coverage Matters
For Lenders and Investors
Lenders and investors use asset coverage ratios to gauge how risky it is to lend money to or invest in a company. Higher asset coverage means more cushion and less risk that the company won’t be able to pay what it owes.
Bond rating agencies examine asset coverage when assigning ratings to a company’s bonds. Higher ratings mean they think the bonds are safer, mainly because of solid asset coverage.
For the Company
From the company’s perspective, strong asset coverage can help them get cash when needed. With high asset coverage, they can issue bonds or preferred stock on good terms because lenders and investors see them as low risk.
But the company has to strike a balance. If it ties up too many assets, promising to use them to cover debts, it might not have the flexibility to use those assets for other important things, like expanding the business or weathering tough times.
The Big Picture
Asset coverage is one piece of the puzzle when judging a company’s financial health and riskiness. Lenders and investors also consider cash flow, earnings, and overall market conditions.
But in a world of complex financial deals and promises, asset coverage cuts through the noise with a simple question: Does this company have enough stuff to back up its promises?
For a simple concept, asset coverage can get pretty technical pretty fast. But at its core, it’s about trust. The company says, “You can trust us to pay you back because look at all this valuable stuff we’ve got.” And in the high-stakes world of corporate finance, that trust is everything.
