Question

How effective do you feel financial ratios can be at predicting bankruptcy? Is debt always considered risky? Why or why not?

Answer 1

Financial ratios are used for many things such as using Profitability ratios to check whether investing in company is profitable for investors or not..Liquidity ratios to check whether company has adequate liquid funds to meet it's short term liabilities..Activity ratios to know whether there is optimum utilization of resources by company or not..Debt ratio whether company has maintained a balance between it's sources of financing and how capable it is to meet it's long term debts etc. But financial ratios can provide only as much reliable information as much reliable is the data of company from which it is made.If data is accurate and ratios are used effectively than it can be known in advance whether company is heading towards Bankruptcy so that appropriate actions can be taken by management and those charged with governance within time in order to avoid such outcome. The main thing checked for bankruptcy is whether company is under 'Financial distress' which is a phase when company is unable to meet it's debt obligations whenever they fall due. This can be a major reason leading to company's bankruptcy and using appropriate ratios such as 'Debt to Equity ratio' , 'Cash flow to debt ratio' , 'Total asset to debt ratio' etc and data from other financial ratios can be analyzed and measured whether company is in a situation of financial distress and if so than what necessary decisions will prevent such outcomes. Financial ratios are very effective at predicting bankruptcy on a reliable scale depending on realiabilty of financial data as well
Debt is a very popular source of financing because when we raise capital through Debt then there is no dilution of ownership as debt holders have no interest in profits of company like shareholders and they are only concerned with timely payment of a predetermined interest rate as well as redemption of their debt at time of maturity. Debt can risky if too much financing is done through Debt because interest expense is something that has to met even if the company is incurring losses , unlike the case in shareholders where dividend payment can be withheld if the company chooses. If company is in a situation of financial distress than Debt financing can be considered risky. At the same time when company is in a profitable position than debt is considered favorable as debt holders's interest is fixed and may take only a small portion of company's earnings . But the market and in it every business's conditions remains uncertain and fluctuating . Today a profitable company may start incurring losses in following years, therefore debt should be used after careful analysis so that it does not become too risky and remains within the control of company even in hard situations.