What is the Asset-Coverage Test? A Comprehensive Legal Overview

Q: How is the asset-coverage ratio calculated?

It is calculated by dividing net tangible assets by long-term debt.

Q: What happens if a company fails the asset-coverage test?

It may face restrictions on additional borrowing and could be in violation of its bond indenture.

Definition & Meaning

The asset-coverage test is a financial requirement often included in bond indentures. It allows a company to take on additional debt only if its ratio of assets to debt meets a predetermined minimum threshold. Typically, this ratio is calculated using net tangible assets compared to long-term debt. This test is designed to protect creditors by ensuring that the company maintains a sufficient level of assets relative to its obligations.

Table of content

Legal Use & context

The asset-coverage test is primarily used in corporate finance and securities law. It is relevant in situations where companies issue bonds or other debt instruments. Legal practitioners may encounter this term when drafting or reviewing bond indentures, ensuring compliance with financial covenants, or advising clients on borrowing strategies. Users can manage some of these processes themselves with tools like US Legal Forms, which provide templates for bond agreements and related documents.

Key legal elements

Real-world examples

Here are a couple of examples of abatement:

(Hypothetical example) A corporation has $5 million in net tangible assets and $3 million in long-term debt. Its asset-coverage ratio is 1.67. If the bond indenture requires a minimum ratio of 1.5, the corporation can borrow additional funds. However, if its assets decrease to $4 million while the debt remains at $3 million, the ratio drops to 1.33, violating the bond covenant and restricting further borrowing.

Comparison with related terms

Term	Definition	Differences
Debt Covenant	A clause in a loan agreement that requires the borrower to fulfill certain conditions.	The asset-coverage test specifically measures asset-to-debt ratios, while debt covenants can cover a broader range of financial metrics.
Leverage Ratio	A financial ratio that measures the degree of a company's debt compared to its equity.	The asset-coverage test focuses on assets versus debt, while leverage ratios compare debt to equity.

Common misunderstandings

What to do if this term applies to you

If you are considering borrowing against your assets, it is essential to understand the asset-coverage test and how it affects your borrowing capacity. Review your financial statements to calculate your asset-to-debt ratio. If you are unsure about compliance with bond indentures or need assistance, consider exploring US Legal Forms for templates related to bond agreements. For complex situations, consulting a legal professional is advisable.

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Quick facts

Typical Use: Corporate borrowing
Key Metric: Asset-to-debt ratio
Common Minimum Ratio: Varies by indenture, often around 1.5
Potential Consequences: Restricted borrowing if the ratio falls below the minimum