As we all know, investing in companies can be very profitable, but also quite risky. That is why it is essential that we know how to analyze a company and know how to interpret the numbers. A good help for this task is the guarantee ratio, through which we will know how close a company is to bankruptcy.
If you are not completely clear about what this concept is, do not worry. In this article we explain what is the guarantee ratio, how is it calculated and what is the correct way to interpret it.
What is the guarantee ratio?
Before explaining exactly what a guarantee ratio, also known as a guarantee coefficient, is, let's first clarify what "ratio" means in economics. It is a quantitative relationship that exists between two different phenomena and that reflects a specific situation regarding the level of investors, profitability, etc. Ratios are widely used in the world of finance and are essential to clarify ideas and make decisions.
Regarding the guarantee coefficient, this is basically a metric that is used to find out what is the risk of bankruptcy that a specific company has. Later we will discuss exactly how to calculate it, but for now we can stick with the idea that a formula is used that relates the company's debt to its assets. We are going to comment below on the keys of the guarantee ratio and the application it has in the corporate environment.
As we have already mentioned before, the guarantee coefficient reflects how far or how close a company is to being technically bankrupt. Therefore, Analyze the solvency of a company. In order to be able to analyze its financial situation, this ratio compares the liabilities due with the real assets of the company. But what are these concepts? Well, the real assets of the company are those that would have a real value in the event of a liquidation. As for the liabilities, it is basically the indebtedness that the company supports.
In the case of bankruptcy, the guarantee ratio can tell us if the company would be able to meet the debt it has. To do this, of course, he would have to sell his assets. So that, this indicator is both an internal and an external reference. Internal, because it reflects the situation of the company in the eyes of its administrators. External, because it reflects the risk assumed by hypothetical investors.
How is the guarantee ratio calculated?
Now that we know what the guarantee ratio is, we are going to explain how to calculate it. The correct formula for this task is the division of the real assets of the company between the liabilities due. This indebtedness also includes those debts that the company may have with suppliers, with the Treasury, with banks or with any other type of creditor. So, the formula would be the following:
Guarantee ratio = Real assets of the company / Required liabilities (indebtedness)
To make it clearer, we are going to use a transport company as an example. The real assets, that is, those assets that could be sold in the event of liquidation, are made up of four delivery vans and a logistics warehouse. In total they have a value of 2,4 million euros. As for debts, this company owes 850 thousand euros to various creditors and 140 thousand euros to the Treasury. The total payable liability would therefore be 990 thousand euros. With these numbers we will apply the formula:
Guarantee ratio = 2.400.000 / 990.000 = 2,42
Thus, the guarantee ratio of this transport company is 2,42. And what does this number tell us? According to traditional corporate metrics, for a situation to be considered normal, the guarantee ratio must be between 1,5 and 2,5. This is the case of the company that we have set as an example. But what happens if the ratio is below or above these levels? We will comment on it below.
Acting
We already know how to calculate the guarantee ratio and what are the values considered normal for a company. However, we can find cases in which the guarantee coefficient is below or above normal levels. How is it interpreted in those cases?
If after performing the calculation correctly, the guarantee ratio of a company is below 1,5, it is a bad sign. This means that the company in question is about to go bankrupt. So the lower the guarantee ratio, the more risk that company has. What happens in these cases is that the sale of the company's assets will not be enough to cover all the payable liabilities, that is, all the debts that the company has.
Let's give an example for a guarantee ratio below normal. Let's say that a company has assets whose value is 56 million euros. However, it has enforceable debts of a total of 67 million euros. If we apply the formula (guarantee ratio = 56 million / 67 million), we will find that the guarantee ratio is 0,84. As is obvious just by looking at the value of its assets and the debt that the company has accumulated, only with the sale of those assets it could not solve its debts.
The opposite case could also occur: A company whose guarantee ratio is greater than 2,5. When the coefficient is so high, it does not mean that the situation of the company is healthy. It's more: When the guarantee ratio is very high, this means that the company in question is not using enough external financing. This fact can prevent the company from undertaking certain investments, deducting interest on the debt or distributing dividends, since it sacrifices an important part of the profit to invest.
Now that we know what the guarantee ratio is, what its formula is and how to interpret it, it will be of great help when researching companies for future investments. Remember that It is very important to do a good analysis before making a decision.