Warning Signals in Financial Ratios

This is by no means an exhaustive list, but any one of the signals could mean there is a problem. The more warning signals there are, the higher the risk.

1. Is current ratio declining?

The current ratio is a financial metric that measures a company’s ability to pay its short-term liabilities using its short-term assets. It is calculated by dividing a company’s current assets by its current liabilities. The current ratio is considered a liquidity ratio, which measures a company’s ability to meet its short-term financial obligations. A ratio of 1 or higher is considered to indicate that a company has enough liquid assets to cover its short-term liabilities, while a ratio of less than 1 may suggest that a company is struggling to meet its short-term financial obligations.

If a company’s current ratio is declining, it may indicate that the company is having difficulty managing its short-term liabilities. It could be a sign of financial stress and potential liquidity issues. To analyze the situation, it would be important to look at the company’s cash flow, as well as other financial metrics such as the quick ratio and debt to equity ratio. Additionally, it would be beneficial to review the company’s operational and industry-specific factors that may be impacting its financial performance.

2. Is current ratio/quick ratio/cash ratio low?

The quick ratio (also known as the “acid test ratio”) is calculated by dividing a company’s quick assets (cash, cash equivalents, and short-term investments) by its current liabilities. Quick assets are the most liquid assets a company has and are expected to be converted into cash within 90 days. The quick ratio is considered a more stringent measure of liquidity than the current ratio, as it excludes inventory and other current assets that may be harder to liquidate quickly.

The cash ratio is calculated by dividing a company’s cash and cash equivalents by its current liabilities. It is the most stringent measure of liquidity as it only considers the cash and cash equivalents that a company has on hand to meet its short-term financial obligations.

A ratio of 1 or higher for both ratios is good, as it indicates that a company has enough liquid assets to cover its short-term liabilities. A ratio lower than 1 may suggest that a company is struggling to meet its short-term financial obligations.

If a company’s current ratio, quick ratio, or cash ratio is low, it may indicate that the company is struggling to meet its short-term financial obligations. This can be caused by several factors, including:

Insufficient cash flow: If a company is not generating enough cash to meet its current obligations, it may struggle to pay its bills on time.
High levels of debt: A company that has a high amount of debt relative to its assets may find it difficult to meet its short-term financial obligations.
Slow inventory turnover: If a company is not able to sell its inventory quickly, it may have too much stock on hand and not enough cash to meet its short-term financial obligations.
High accounts payable: If a company has a high amount of accounts payable, it may not have enough cash to pay its bills on time.

To analyze the situation, it would be beneficial to review the company’s cash flow statement and balance sheet, as well as other financial metrics such as the debt-to-equity ratio and the times interest earned ratio. Additionally, it would be helpful to review the company’s operational and industry-specific factors that may be impacting its financial performance. It is also important to compare the company’s liquidity ratios with its competitors and industry average to see how the company is performing in comparison.

3. Is company generating positive cash?

If a company is not able to generate positive cash flow, it may be experiencing financial stress and difficulty in meeting its financial obligations. This can be caused by several factors, including:

Operating losses: If a company is not generating enough revenue to cover its operating expenses, it may not have enough cash to meet its financial obligations.
High levels of debt: A company that has a high amount of debt relative to its assets may find it difficult to generate positive cash flow. The high interest payments on its debt can consume a significant portion of the company’s cash flow.
Slow inventory turnover: If a company is not able to sell its inventory quickly, it may have too much stock on hand and not enough cash to meet its financial obligations.
High accounts payable: If a company has a high amount of accounts payable, it may not have enough cash to pay its bills on time.

To analyze the situation, it would be beneficial to review the company’s cash flow statement, income statement and balance sheet. Additionally, it would be helpful to review the company’s operational and industry-specific factors that may be impacting its financial performance. It is also important to compare the company’s cash flow performance with its competitors and industry average to see how the company is performing in comparison. It may also be beneficial to analyze trends in the company’s cash flow over time to identify any underlying issues that may be contributing to the lack of positive cash flow.

4. Are debtor days rising?

Debtor days (also known as days sales outstanding or DSO) is a financial metric that measures the average number of days it takes a company to collect payment from its customers after a sale has been made. It is calculated by dividing the company’s accounts receivable by its average daily sales.

If a company’s debtor days are rising, it may indicate that the company is having trouble collecting payments from its customers. This can be caused by several factors, including:

Weak credit policies: If a company is not properly screening its customers or has lax credit terms, it may be extending credit to customers who are not able to pay on time.
Economic downturns: A recession or other economic downturn can make it more difficult for customers to pay their bills on time, resulting in rising debtor days.
Increased competition: If a company is facing increased competition, it may be forced to offer more favorable credit terms or longer payment terms to attract customers.
Inefficient credit and collections processes: If a company’s credit and collections processes are not efficient, it may take longer for the company to collect payments from its customers.

To analyze the situation, it would be beneficial to review the company’s accounts receivable aging report, as well as other financial metrics such as the accounts receivable turnover ratio. Additionally, it would be helpful to review the company’s operational and industry-specific factors that may be impacting its credit and collections processes. It is also important to compare the company’s debtor days with its competitors and industry average to see how the company is performing in comparison. It may also be beneficial to analyze trends in the company’s debtor days over time to identify any underlying issues that may be contributing to the increase.

5. Are inventory ratios rising & profitability ratios declining?

If a company’s inventory ratios (such as inventory turnover, days sales in inventory) are rising and its profitability ratios (such as gross margin, return on assets) are declining, it may indicate that the company is having difficulty managing its inventory effectively. This can be caused by a number of factors, including:

Overproduction: If a company is producing too much inventory, it may have a surplus of stock that it is unable to sell quickly, leading to rising inventory ratios and declining profitability ratios.
Insufficient demand: If a company is not able to sell its inventory quickly, it may indicate that there is insufficient demand for the company’s products or services.
Price competition: If a company is facing intense price competition, it may be forced to lower its prices, resulting in lower profitability ratios.
Inefficient inventory management: If a company’s inventory management processes are not efficient, it may struggle to keep its inventory levels in line with demand, leading to rising inventory ratios and declining profitability ratios.

To analyze the situation, it would be beneficial to review the company’s inventory turnover ratio, days sales in inventory, and other inventory management ratios. Additionally, it would be helpful to review the company’s operational and industry-specific factors that may be impacting its inventory management processes and profitability ratios. It is also important to compare the company’s inventory and profitability ratios with its competitors and industry average to see how the company is performing in comparison. It may also be beneficial to analyze trends in the company’s inventory and profitability ratios over time to identify any underlying issues that may be contributing to the problem.

6. Is gearing high?

If a company has a high level of gearing, it means that the company has a high level of debt relative to its equity. This can be a cause for concern because a high level of debt can increase a company’s financial risk and make it more vulnerable to economic downturns or interest rate fluctuations.

A high gearing ratio can be caused by several factors, including:

High levels of debt: A company that has taken on a high amount of debt may have a high level of gearing.
Low equity: A company with low equity relative to its debt will have a high level of gearing.
Aggressive expansion: A company that is growing rapidly through acquisition or expansion may have a high level of gearing if it is funding this growth primarily through debt.

To analyze the situation, it would be beneficial to review the company’s debt to equity ratio, as well as other financial metrics such as the interest coverage ratio. Additionally, it would be helpful to review the company’s operational and industry-specific factors that may be impacting its debt levels. It is also important to compare the company’s gearing ratio with its competitors and industry average to see how the company is performing in comparison. It may also be beneficial to analyze trends in the company’s gearing ratio over time to identify any underlying issues that may be contributing to the high level of gearing.

7. Is debt funding not linked to assets being financed?

If debt funding is not linked to the assets being financed, it can create several issues for a company. Some of these issues include:

Misallocation of resources: If a company is borrowing money to fund projects or operations that do not generate enough cash flow to service the debt, it can lead to a misallocation of resources and a strain on the company’s finances.
Reduced flexibility: When a company has a large amount of debt that is not linked to specific assets, it can be difficult for the company to generate enough cash flow to meet its debt obligations. This can limit the company’s flexibility to respond to changes in the market or the economy.
Higher risk of default: When a company has a prominent level of debt that is not linked to specific assets, it increases the risk of default in case of unexpected events such as economic downturns or changes in the interest rate.
Reduced profitability: If a company is using debt to fund operations or projects that do not generate enough cash flow, it can lead to reduced profitability and lower returns for shareholders.

To mitigate these issues, companies should ensure that their debt is linked to assets that generate enough cash flow to service the debt, and that they have a clear understanding of how the assets financed by debt will generate enough cash flow to support the debt service. Additionally, companies should have a clear debt management strategy in place and regularly review their debt levels and debt-to-equity ratios to ensure they are comfortable with the level of risk they are taking on.

8. Do profitability ratios appear satisfactory, but cash flow profitability ratios don’t?

If a company’s profitability ratios appear satisfactory but its cash flow profitability ratios do not, it may indicate that the company is having trouble converting its profits into cash. This can be caused by several factors, including:

High levels of working capital: If a company has elevated levels of working capital, such as inventory or accounts receivable, it can consume cash and reduce cash flow profitability.
High capital expenditures: If a company is making high capital expenditures, such as investing in new equipment or facilities, it can reduce cash flow profitability.
High levels of debt: A company that has a high amount of debt relative to its assets may find it difficult to generate positive cash flow, even if its profitability ratios are satisfactory.
Timing differences: A company may have recognized revenue but not received cash yet or have paid out cash but not yet recognized the expense, which can affect the cash flow profitability ratios.

To analyze the situation, it would be beneficial to review the company’s cash flow statement, income statement and balance sheet. Additionally, it would be helpful to review the company’s operational and industry-specific factors that may be impacting its cash flow. It is also important to compare the company’s cash flow profitability ratios with its competitors and industry average to see how the company is performing in comparison. It may also be beneficial to analyze trends in the company’s cash flow profitability ratios over time to identify any underlying issues that may be contributing to the problem.