Four Ways to Identify Companies at Risk of Going Bankrupt

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The worst possible outcome for a stock is bankruptcy. When a company files for bankruptcy, its shares are first delisted and then are eventually eliminated.

This fact was obviously lost on speculators who bid up shares of Revlon Inc. (REV) from $1.95 to as high as $9.89 after the company filed for Chapter 11 bankruptcy two weeks ago.

Revlon’s bankruptcy provides the opportunity to talk about warning signs to watch out for. A few key ratios and indicators can quickly tell you if a company is at risk of not being able to handle its debt.

An obvious metric is the level of total liabilities relative to total assets. It’s easy to judge with a quick glance at the balance sheet. Revlon ended its first quarter with a total-liabilities-to-total-assets ratio of 187.5%. To put this number in perspective, Revlon’s proportionate debt level ranked in the highest 3% of all publicly traded companies. Yikes!

A high level of debt can be sustained if a company has the financial ability to meet its payment obligations. One way to determine this is to compare interest expense to earnings. These figures can be found on a company’s income statement. The times interest earned ratio (aka the interest coverage ratio) will give a more proportionate ratio than just eyeballing the levels. This ratio should regularly be above 1.0, which means earnings exceed interest expense. Ratios below 1.0 indicate that interest expense exceeds earnings. Revlon’s times interest earned ratio has been below 1.0 every year since 2016.

Cash from operations tells you whether a company’s normal business operations generate more cash than they use (cash flow positive) or burn through more cash than they generate (cash flow negative). Sustained negative cash flow from operations leaves a company at the mercy of its debtors and/or equity backers. Revlon had negative cash from operations every year between 2017 and 2021. Cash from operations can be found on the company’s cash flow statement.

A final way of gauging the risk of bankruptcy is to use the Altman Z-score. It was specifically developed to determine whether a company is at risk of incurring financial distress. We use Altman’s Z-double prime score in the A+ Investor and VMQ Stocks quality grades. Scores above 3.0 indicate that a company is not at risk of distress. Scores below 1.8 indicate that a company is likely headed for distress. Revlon’s Z-double prime score was –0.35 prior to filing for bankruptcy.

Any investor doing a cursory look before the bankruptcy filing would have recognized Revlon as a very risky stock by using one or more of these metrics. As investors, we help our portfolio performance by knowing when to eliminate a given stock from consideration.