The fixed asset coverage ratio is the risk measurement tool or ratio used to compute the ability of a company to pay its debt by selling its fixed assets. It gives an idea about the company’s capability to meet up with its debts to the investors. And by checking this ratio, the investor can easily understand the fixed asset requirements for the ideal company by which they can settle down their debt obligations. The company mainly uses the three primary sources to get retained earnings, equity, and debts. In this article, we will understand about fixed asset coverage ratio and its usage with limitations.
What is Fixed Asset Coverage Ratio?
As a wise investor, you know equity shareholders are the owner of the company. If the company does not have a remaining profit, then it will not get any profit. And debt investors are the company’s liability, and they get interested in their given loans whether the company makes a profit or not. And if the company faces a massive loss, it requires selling its assets to raise funds for paying its debts.
So, to understand the company’s net assets and its net debts, the equity and debt investors can check out the fixed asset coverage ratio of the company. So that they can understand how a company can repay its debt to investors. Many business analysts use this ratio to understand the company’s financial stability. The higher coverage ratio represents the better status of the company before the investors. Hence as an investor, you might be looking for the high asset coverage ratio of the company so you can assure yourself you are investing in the right company.
Fixed Asset Coverage Ratio Formula
If you want to calculate the fixed asset coverage ratio, then you need to use the formula. Below there is detailed information about the asset coverage ratio formula.
Fixed Asset Coverage Ratio = ((Total Asset Of The Company-Total Intangible Asset Of The Company)-(Current Liability Of The Company- Short Term Portion Of The Long Term Debt Of The Company))/Total Debt Of The Company In The Respective Year
This is the formula by which you can calculate the asset coverage ratio of the company. And here, the total asset includes the aggregate of tangible and intangible assets from which you need to minus the value of the intangible asset. In total current liability, you need to minus short-term debts or those that need to be paid within a year. After doing this, you need to minus the total asset with the total current liability that you calculated using the formula. And after this, you need to divide the remaining value with the total debt of the company.
Let’s understand this ratio with the help of an example.
Example of Fixed Asset Coverage Ratio
Suppose the company A Ltd has the following figure, and you need to calculate the asset coverage ratio.
Total asset: Rs50,00,000
Intangible asset: Rs15,00,000
Current liabilities: Rs 5,00,000
Short term debts: Rs3,00,000
Total debt: Rs2,90,000
So, if we use our formula then the it will be like this
= ((50,00,000-20,00,000)-(12,00,000-4,00,000))/8,00,000 = 2.75
In this case, we get the asset coverage ratio of 2.75, which shows the capability of A Ltd to meet its debt obligations. Typically, most investors look for the ACR around 2, and it is the standard ratio that a company should maintain. In this case, the ratio is 2.75, more than one and more than the standard ratio. Hence investors will love to invest in this company. However, if the company deals in utility products, having a 1-1.5x ratio is also a good sign for investors. On the other hand, if the company has a capital goods business and has maintained its ratio of 1.5x to 2.0x, it is a good sign for the investor.
Interpretation and Analysis Using Fixed Asset Coverage Ratio
So, as per the example mentioned above, the company has secured its fixed asset coverage ratio to 2.75x. And it is an excellent sign for investors, shareholders, and debt investors. So, whether the company belongs to utility or capital goods, investors will show their investment in investing in this company. However, if it gets below 1x, i.e., 0.95x, it will not be suitable for the company. It is the red signal for the investors, and they will prevent investing in such companies. Also, we discussed that the utility company must keep its fixed asset coverage ratio from 1x to 1.5x. And capital goods companies should keep their fixed asset coverage ratio from 1.5x to 2.0x.
Use of Fixed Asset Coverage Ratio
The asset coverage ratio is used for determining the risk level of the investment in a company. This ratio is the measurement for identifying the risk level of bankruptcy because it is also called the solvency ratio.
Using this ratio, the investor, shareholders, and debt investors can examine the company’s debt obligation. And they can also understand the stability, capital management, risk level, and capital structure of the ideal company.
If the ratio is over 2x, it will indicate to investors that there is the possibility of making a profit. Hence they will show their interest to invest in such a company, and the company will quickly raise its funds. The high ratio also represents a minimal risk that the company will suffer from any bankruptcy risk.
Also, if the company has a high asset coverage ratio, it will negatively affect the investor. As they will assume that the company is not expanding its capital structure and not maximizing the earnings of its investors. Moreover, there is no optimized solvency ratio rate, and it depends upon the type of business a company does.
Limitation of Fixed Asset Coverage Ratio
There are some limitations with this ratio, and below are some of them. So you can find these to understand the limitation of the fixed asset coverage ratio as well.
1. Non-Feasible Comparison
Generally, different companies based in different industries use different capital structures. And the coverage ratio is used for determining the risk level. However, at many stages and lifespan of a company, they change their capital structure. Hence, using a coverage ratio is not feasible; therefore, the investor has to be aware of other terms.
2. Accurate Interpretation
The values for calculating the coverage ratio are taken from the company’s balance sheet. And balance includes the value of assets and liabilities based on the book value. It does not include the market value. Hence, there is no guarantee about the accurate ratio and interpretation.
So, in this article, we learned about the fixed asset coverage ratio, and we discovered many other terms. We understood how to calculate the fixed asset coverage ratio and covered an example for more understanding. Thus, I assume you loved reading this exciting article. If you want to keep reading such fantastic information, stay with us.