There are some financial
ratios that can be used to reveal that companies are facing financial distress
and perhaps one step before bankruptcy. One of the first ratio used is the current
ratio, which divides current assets to current liabilities. It simply says
that if current assets are greater than current liabilities, then the company is
in good standing. This is a ratio that measures if the company is in a position
to cover its short term (one year) liabilities using its current assets, the
most liquid form of assets. Those that can be easily converted to cash. A ratio
of >2 is a good sign that current assets are two times higher than the
current liabilities. A ratio of <1 is a warning signal.
Operating cash flow to
sales – a company that generates cash and cash flow is
generating cash. It means that customers are buying its products and services,
or cash is coming into the company, and at the same time cash is flowing out to
meet the company’s liabilities. Operating cash flow divided by sales revenue
indicates if a company can generate cash from its sales. If cash flow does not
increase in line with sales, then there is a problem indicating that the
company is not able to collect its accounts receivables. Accounts receivables
are short term assets which are not yet collected from customers. The higher
the ratio the better.
The debt to equity
ratio, D/E, is a frequent indicator of evaluating the financial health of a
company. This is a leverage ratio and measures a company’s ability to meet its
financial obligations (paying its debt), and how the company is financially
structured, that is, the amount of equity and debt used. If this ratio is high
it means that the company is heavily dependent on debt financing, rather that
equity (from investors). This ratio is used by banks to determine if financing
is to be extended to the company. Obviously if this ratio is high, credit will
unlikely be giving to the company since it will be considered a highly levered
company, thus high risk.
Cash flow to debt
ratio – cash flow from operations / total debt. Cash flow is essential to any
company to meet its operations. This ratio indicates the time it will take
(theoretically) to retire its outstanding debt, assuming that all of its cash
flow is dedicated to debt payment. If this ratio is high (cash flow), then it
will comfortably cover its debt and still have cash remaining.
