Reading: Financing Alternatives

Finally, also the asset coverage ratios provides useful information about the financial strength of a company. The golden rule of the balance sheet states that long-term assets should be backed by long-term capital. If not, for example because property, plants, and equipment are financed with one-year bank loans, the mismatch of maturities exposes the firm to a potentially significant refinancing risk.

There are two popular ways to compute asset coverage ratios. The first one devides the book value of equity by the book value of fixed assets (noncurrent assets) and thereby indicats with how much equity a dollar of fixed assets is backed:

Asset coverage ratio I = \( \frac{\text{Book equity}}{\text{Fixed assets}} \)

The second version of the ratio adds long-term debt to the numerator. It therefore indicates with how much long-term capital (debt plus equity) a dollar of fixed assets is backed:

Asset coverage ratio II = \( \frac{\text{Long-term debt} + \text{Book equity}}{\text{Fixed assets}} \)

According to the "golden rule" mentioned above, the ratios (in particular the second version) should be close to 1.

Let us practice these ratio again using Hershey's financial information. We know from Hershey's 2015 balance sheet that the book equity was approximately 1 billion, that the firm had long-term debt of approximately 1.6 billion, and that the firm had noncurrent asset with a book value of approximately 3.5 billion.

These numbers imply an asset coverage ratio I of 0.3 and an asset coverage ratio II of 0.75:

Asset coverage ratio I = \( \frac{\text{Book equity}}{\text{Fixed assets}} = \frac{1'047}{3'496} = 0.30 \)

Asset coverage ratio II = \( \frac{\text{Long-term debt} + \text{Book equity}}{\text{Fixed assets}} = \frac{1'557+1'047}{3'496} = 0.75 \)

Put differently, a dollar of fixed assets was backed by 30 cents of equity and 75 cents of long-term capital.