Financial Ratios to Spot Companies Headed for Bankruptcy

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Financial Ratios to Spot Companies Headed for Bankruptcy

While investors examine shares from a variety of analytical angles, such as profitability ratios, income ratios, and liquidity ratios, they should be cautious to include financial measurements that may particularly be used to offer early warning signs of potential approaching bankruptcy. Key ratios may convey such signals far in advance, allowing investors plenty of time to sell their share stake before the financial roof collapses.

Key Takeaways

  • Aside from profitability measures, investors benefit from employing financial ratios to analyze investments, particularly as a warning indication of imminent insolvency.
  • The current ratio assesses a company’s ability to manage its short-term indebtedness.
  • The operational cash flow to sales ratio assesses a company’s ability to produce cash from sales.
  • The debt-to-equity ratio assesses a company’s capacity to satisfy its financial commitments and the structure of its financing.
  • The cash flow to debt ratio indicates how long it would take a firm to pay off all of its debt if all of its cash flows or free cash flows were allocated to it.

Current Ratio

One of the key liquidity measures used to evaluate a company’s financial stability is the current ratio, which essentially divides current assets by current liabilities. It assesses a company’s capacity to handle all of its short-term debt commitments by determining the sufficiency of the company’s present resources to meet all of its debt obligations for the next 12 months. A greater current ratio reflects the company’s liquidity. A current ratio of 2 or greater is generally considered healthy. A ratio of less than one is a clear danger indication.

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Operating Cash Flow to Sales

Cash and cash flow are critical to a company’s success and survival. The operational cash flow to sales ratio, which is calculated by dividing operating cash flow by sales revenue, demonstrates a company’s capacity to earn cash from its sales. Parallel growth are the optimal connection between operational cash flow and sales. If cash flows do not rise in tandem with sales growth, this is reason for worry and may indicate poor cost or receivables management. As with the current ratio, the larger this ratio, in general, the better. Analysts want to see results that improve or remain steady over time.

Debt/Equity Ratio

The debt/equity (D/E) ratio, often known as the leverage ratio, is one of the most commonly used ratios for assessing a company’s financial health. It gives a fundamental measure of a company’s capacity to satisfy funding commitments as well as the form of its financing, whether it comes mostly from equity investors or primarily from debt financing. If this ratio is high or rising, it suggests that the firm is unduly reliant on debt financing rather than capital given by equity investors.

The ratio is particularly significant since it is one of the elements that lenders assess. Lenders may be reticent to give more loans to the firm if they consider the ratio is becoming uncomfortably high. An ideal D/E ratio is about one, with equity nearly equaling liabilities. Although the D/E ratio varies by industry, a ratio greater than 2 is generally deemed harmful.

Cash Flow to Debt Ratio

Cash flow is critical to the success of any firm. No firm can function without the required funds to pay bills, make loan, rental, or mortgage payments, meet payroll, and pay taxes. The cash flow to debt ratio, which is computed by dividing cash flow from operations by total debt, is commonly regarded as the single greatest indicator of financial company failure.

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This coverage ratio is the potential time required for a corporation to repay all of its outstanding debt if 100% of its cash flow was committed to debt service. A higher ratio suggests that the corporation is better capable of servicing its debt. Some analysts calculate free cash flow rather than cash flow from operations since free cash flow includes capital expenditures. A ratio greater than one is typically seen as healthy, but any result less than one is often taken as indicating potential insolvency within a few years unless the firm takes significant action to improve its financial status.

The Z-score, which is a compilation of many financial measures used to build a single composite score, is another statistic often used to forecast impending bankruptcy.

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