Asset cover

[kylie jane]

Can someone explain to me why the alternate definition of asset cover is less conservative (page 11, chapter 12).

Normal defn = (total assets - current liabilities -intangible assets)/(loan capital +all prior charges)

Second defn= (total assets - current liabilities -intangible assets)/( total loan capital)

I would have thought the second definition was more conservative not less?

 

[ZebuAlex]

You are dividing by a smaller number, hence you come up with a higher asset cover for the 2nd definition. That is why it is less conservative.

 

[kylie jane]

So when they say total loan capital they are referring to one loan only not the sum of all loan capital?

 

[Margaret Wood]

My colleagues and I have had a think about this today and we think the use of the term "less conservative" for the second formula is rather strange. The second definition has total loans on the bottom and so gives a lower ratio than the first definition. In the example on page 12 of Chapter 12, the first definition gives an asset cover of 9.4 for debentures whereas the second definition gives a ratio of 1.5. The second definition is much tighter and sounds much more frightening for debenture holders - hardly less conservative, if we take "conservative" to be "cautious".

One of my colleagues suggests that "less conservative" might mean that it is less conservative about the loans that it selects for the bottom line, ie it includes all loans, whether they rank above or below the loans we're investigating.

I think we need to get in touch with the profession to ask what they mean!

 

[kylie jane]

Thanks Margaret, I'm glad it seems counter intuitive to you too!