Tangible assets consist of real and fixed property -- such as land, buildings and machinery -- plus current assets, which include inventory and receivables. A tangible asset coverage ratio is based on the book value (BV) or net asset value (NAV) of a company's tangible assets, which is used to evaluate a company's ability to cover all debt obligations. The test takes into consideration the relationship among tangible and intangible assets, short term debt and liabilities in an effort to establish a picture of the company's financial health at a given moment.
Tangible Asset Coverage Ratio Defined
The tangible asset coverage ratio is a formula that determines the financial health of a company by determining the company's ability to cover debt obligations with current tangible assets after satisfying all liabilities. This formula provides investors and management an empirical analysis of the financial quality of a company.
Tangible Asset Coverage Ratio Formula
Calculating the asset coverage ratio (ACR) requires calculating all current liabilities and then subtracting all short term (ST) debt obligations. The resulting sum from this calculation is then subtracted from the sum of the book value of all tangible and monetary assets. One deficiency in this formula is the use of book value instead of the liquidation value as a formula metric. Liquidation value tends to be lower than the book value, thereby distorting the actual value and ability of the company to cover existing debt. ACR = ((BV Total Assets – Intangible Assets) – (Current Liabilities – ST Debt)) / Total Debt Obligations
Book Value Calculation
Book value is an essential metric required to calculate the asset coverage ratio. Book value or carrying value is the net asset value (NAV) of an asset carried on the balance sheet (statement listing assets, liabilities and shareholder's equity). The NAV is determined by taking the original asset cost minus accumulated depreciation (the reduction of an asset's value over time for tax and valuation purposes). Book value (BV) is determined by subtracting intangible assets and liabilities from total assets (tangible and monetary assets). BV = Total Assets - (Intangible Assets + Liabilities)
Purpose of Asset Coverage Ratio
From an investor's perspective, a low reading of the tangible asset coverage ratio -- below 1.5 for utility companies and below 2 for other industries -- indicates a riskier investment based on the belief that a sub-par coverage ratio indicates a higher chance of bankruptcy. From the corporate management perspective, low asset coverage ratios indicate that accumulating more debt would be problematic because the company would be unable to meet current debt obligations. So, for both investors and management, the asset coverage ratio is one factor to use when evaluating the financial health of a company.