A friend has mentioned that she has read somewhere that the following variables can be used...

A friend has mentioned that she has read somewhere that the following variables can be used to predict bankruptcy: (a) the company debt ratio; (b) the interest coverage; (c) the amount of cash relative to sales or assets; (d) the return on assets; (e) the market-to-book ratio; (f) the recent return on the stock; (g) the volatility of the stock returns. The problem is that she can’t remember whether a high value of each variable implies a high or a low probability of bankruptcy. Can you help her out?

Expert Solution

A. high company debt ratio will always reflect risk related to insolvency because when the debt ratio will be higher, it would be related to a higher risk related to bankruptcy and hence high value of debt ratio is meaning high probability of bankruptcy.

B. high value of interest coverage ratio will mean that the company is generating higher amount of income in order to cover with the interest and hence the risk related to bankruptcy will be lower so when the higher interest coverage ratio will be there, the probability of bankruptcy would be lower

C. if there is a high amount of cash relative to sales or asset, then there is a low risk related to insolvency because there will be a higher liquidity on the hands of the company. Hence the probability of bankruptcy will be lower.

D. If there is high return on assets, it will mean that the probability of bankruptcy will also be lower because when there will be a higher return generated by the company on its assets it is related to safe heaven for the company and probability of bankruptcy will be lower

E. If the market to book ratio is higher it will mean that the risk related to bankruptcy and insolvency is lower

F. If the return on stock is higher, the risk related to bankruptcy is lower because it is meaning that the company is providing with the high rate of return in market

G. when the volatility of the stock return is higher, it will mean that the probability of bankruptcy will also be higher because it is a high beta company and it is having a higher amount of systematic risk.

jeff jeffy answered 2 years ago

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