While investors evaluate equities using several different analytical perspectives, including profitability ratios, income ratios, and liquidity ratios, they should be careful to include financial ratios that can specifically be used to provide early warning signals of possible impending bankruptcy. There are key ratios that can provide such warnings well in advance, giving investors plenty of time to dispose of their equity interest before the financial roof falls in.
The current ratio, which simply divides current assets by current liabilities, is one of the primary liquidity ratios used for evaluating a company's financial soundness. It evaluates a company's capability of handing all its short-term debt obligations, by measuring the adequacy of the company's current resources to cover all of its debt obligations for the next 12 months. A higher current ratio indicates that the company has more liquidity. Generally, a current ratio of 2 or higher is considered healthy. A ratio of less than 1 is a definite warning sign.
Operating Cash Flow to Sales
Cash and cash flow are key to the success and survival of any business. The operating cash flow to sales ratio – operating cash flow divided by sales revenues – indicates a company's ability to generate cash from its sales. The ideal relationship between operating cash flow and sales is one of parallel increases. If cash flows do not increase in line with sales increases, this is cause for concern, and it may be an indication of inefficient management of costs or accounts receivables. As with the current ratio, generally speaking, the higher this ratio is, the better. Analysts prefer to see improving, or at least consistent, numbers over time.
The debt/equity (D/E) ratio, essentially a leverage ratio, is one of the most frequently used ratios for evaluating a company's financial health. It provides a primary measure of a company's ability to meet financing obligations and of the structure of a company's financing, whether it comes more from equity investors or more from debt financing. If this ratio is high or increasing, it indicates the company is overly dependent on financing from creditors as opposed to capital provided by equity investors.
The ratio is also important because it is one of the factors considered by lenders. If lenders believe the ratio is getting uncomfortably high, they may be unwilling to extend further credit to the company. An optimal D/E ratio is about 1, where equity roughly equals liabilities. Although the D/E ratio varies between industries, the general rule is that a ratio higher than 2 is considered unhealthy.
Cash Flow to Debt Ratio
Cash flow is essential to any business; no business can operate without the necessary cash to pay bills, make payments on loans, rentals or mortgages, meet payroll, and pay necessary taxes. The cash flow to debt ratio, calculated as cash flow from operations divided by total debt, is sometimes considered the single best predictor of financial business failure.
This coverage ratio indicates the theoretical period of time that it would take a company to retire all of its outstanding debt if 100% of its cash flow were dedicated to debt payment. A higher ratio indicates a company more soundly capable of covering its debt. Some analysts use free cash flow instead of cash flow from operations in the calculation, because free cash flow factors in capital expenditures. A ratio higher than 1 is generally considered healthy, but any value below 1 is commonly interpreted as signaling impending bankruptcy within a few years unless the company takes steps to substantially improve its financial condition.
Another metric often used to predict potential bankruptcy is the Z-score, which is a combination of several financial ratios used to produce a single composite score.