To know if a company is already near bankruptcy analysts and investors use the following metrics to make informed decisions.
Metric 1: Current Ratio
The current ratio simply divides the current assets by current liabilities. This is one of the main liquidity ratios used in evaluating a company’s financial soundness. It also examines the company’s ability to pay off all of its short term debt obligations.
It measures the company’s current resources and sees if they are enough to cover all of its debt obligations for the next 12 months.
Higher current ratio means that the company has high liquidity. In general, a current ratio of 2 or higher is considered good. A ratio of lower than 1 is treated as a red flag.
Metric 2: Operating Cash Flow to Sale
For any business, healthy cash and cash flow play a crucial role for the survival of that business. The operating cash flow to sales ratio is calculated by dividend cash flow by sales revenues.
This ratio tells something about the company’s capability 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 must be a warning sign. It may be indicating an inefficient management of costs or accounts receivables. As with the current ratio, generally speaking, the higher ratio is better.
Metric 3: Debt/Equity Ratio
The debt/equity ratio is a leverage ratio and one of the most frequently used ratios for evaluating a company’s financial health. It provides a primary measure for the company’s ability to meet financing obligations and of the structure of the company’s financing, whether it comes more from equity investors or more from debt financing.
If the debt/equity ratio is high or increasing, it means the company is highly dependent on financing from creditors as opposed to capital provided by equity investors.
The ratio is also important since it is one of the factors that are considered by lenders. If these lender think that the ratio is getting uncomfortably high, they may be unwilling to extend further credit to the company.
Metric 4: Cash Flow to Debt Ratio
Cash flow is very important for any business since it cannot operate without the necessary cash to pay bills, make payments on loans, rentals, or mortgages, meet payroll, and pay taxes.
The cash flow to debt ratio is calculated by dividing cash flow from operation divided by total debt. This is sometimes considered as the single best predictor of financial business failure.
This coverage ratio tells the theoretical period of time that it would take a company to retire all of its outstanding debt if 100 percent of its cash flow were dedicated to debt payment.
The company is more capable of covering all its debt if the ratio marks higher. Some analysts use the free cash flow instead of the cash flow from operations because free cash flow factors in capital expenditures.
A ratio that is higher than 1 is considered healthy, while any value that’s lower than 1 means impending bankruptcy if the company cannot improve its financial condition. Get the Wibest Broker Forex Education to help with Wibest Top Brokers.