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?

 

Answer

Type of Variable High/Low probability of Bankruptcy Reason

(a) The company debt ratio High Probability of bankruptcy Higher debt ratio means that the company has more external financing than internal financing, leading to high debt repayable. If not paidthen leading to bankruptcy

(b) the interest coverage; Low Probability of bankruptcy High Interest Coverage ratio means that the company will be able to pay the interet on debts within time, hence, it will save the company from being bankrupt

(c) the amount of cash relative to sales or assets; Low Probability of bankruptcy This is because high amount of cash relative to sales or assets means more liquidity and ability to repay all payables

(d) the return on assets;  Low Probability of bankruptcy If returns obtained from assets is high, then the company is getting more return than the aseets it holds, it's a positive indicator

(e) the market-to-book ratio; Low Probability of bankruptcy The price of the share in the market is more than the earnings of the company

(f) the recent return on the stock; Low Probability of bankruptcy The return on stock is hgh means that earning of company is also high

(g) the volatility of the stock returns. High Probability of bankruptcy if volatility is high then its means risk is very high and there are chances of bankruptcy