Bankruptcy Ratios

Bankruptcy Ratios

Many business owners who have filed for bankruptcy say they wish they had seen some warning signs earlier on in their company's downward spiral.  Ratios can help predict bankruptcy before it's too late for a business to take corrective action and for creditors to reduce potential losses.  With careful planning, predicted futures can be avoided before they become reality.  The first five bankruptcy ratios in this section can detect potential financial problems up to three years prior to bankruptcy.  The sixth ratio, Cash Flow to Debt, is known as the best single predictor of failure.

Working Capital to Total Assets Ratio

This liquidity ratio, which records net liquid assets relative to total capitalization, is the most valuable indicator of a looming business disaster.  Consistent operating losses will cause current assets to shrink relative to total assets.

Note: A negative ratio, resulting from negative net working capital, foretell serious problems.

Retained Earnings to Total Assets Ratio

New firms will likely have low figures for this ratio, which designates cumulative profitability.  Indeed, businesses less than three years old fail most frequently.

Note: A negative ratio portends cloudy skies.  However, results can be distorted by manipulated retained earnings (earned surplus) data.

EBIT to Total Assets Ratio

How productive are your business's assets?  Asset values come from earning power.  Therefore, whether or not liabilities exceed the true value of assets (insolvency) depends upon earnings generated.

*EBIT = earnings before interest and taxes

Note: Maximizing rate of return on assets does not mean the same as maximizing return on equity.  Different degrees of leverage affect these separate conclusions.

Sales to Total Assets Ratio

This ratio, which uncovers management's ability to function in competitive situations while not excluding intangible assets, is inconclusive if studied by itself.  But when viewed alongside Working Capital to Total Assets, Retained Earnings to Total Assets, and EBIT to Total Assets, it can confirm whether your business is in imminent danger.

Note: A result of 200 percent is more reassuring than one of 100 percent.

Equity to Debt Ratio

This ratio shows you by how much your business's assets can decline in value before it becomes insolvent.

Note: Those businesses with ratios above 200 percent are safest.

Cash Flow to Debt Ratio

Also, refer to "Debt Cash Flow Coverage Ratio" in the section on "Coverage Ratios".

Since debt does not materialize as a liquidity problem until its due date, the closer to maturity, the greater liquidity should be.  Other ratios useful in predicting insolvency include Total Debt to Total Assets (see "Leverage Ratios" below) and Current Ratio (see "Liquidity Ratios").

*Cash flow  =  Net Income  +  Depreciation

Note: Because there are various accounting techniques of determining depreciation, use this ratio for evaluating your own company and not to compare it to other companies.