There is no single measure for corporate financial health. However, overwhelming debt is often the cause of a firm going bankrupt. Companies with a high debt burden are allowed fewer mistakes than similar companies with more net worth.
The following are a few warning signs that you should look for when analyzing your investment candidates:
- Squeezed by short-term debt: Read the footnotes of the annual report to determine when the company has to repay any short-term debt, discover the interest rate they’re paying, and compare this information to its profit margin. Keep in mind that more than one company has failed because it couldn’t get an extension on its short-term loan.
- Debt/equity ratio: Companies with inflated accounts receivable or inventory need money to support those assets. When the debt to equity ratio is 1.0, the firm is supporting an equal amount of debt and equity. If the debt ratio is less than 0.5, then the firm is considered to be a low debt firm. Therefore, any company with a debt/equity ratio greater than 0.5 can be considered a bankruptcy candidate.
- Debt/income ratio: If the firm is borrowing money to produce goods or services at a rate that is lower than their profits, then debt can be a good thing. Here, debt is divided by the earnings before interest, taxes, depreciation, and amortization. (If you can’t find this number, you can try dividing the debt by the operating income.) Most analysts believe a ratio of between 7 and 8 is sufficient. Bankruptcy candidates often have double-digit debt to income ratios.
- Interest coverage ratio: If the company is borrowing money to make money, that’s business. If a company can’t make its interest payments, that’s bankruptcy. The interest coverage ratio is the operating income divided by that last 12 month’s worth of interest payments. A healthy company will have an interest coverage ratio of 4 or more. However, some highly leveraged companies maintain interest coverage ratios of about 1.5. Bankruptcy candidates have interest coverage ratios that are frequently 1.0 or less.