Avoid losing money with this one ratio

Want to steer clear of companies that go bankrupt? You can with this simple tool.

In Australia, companies that enter bankruptcy usually go into 'administration'. It's such an inoffensive word, conjuring up notions of paper-shuffling and rubber stamps (remember those?).

For shareholders, though, the word 'administration' causes cold sweats. If a company enters administration, you've almost certainly lost your money. To add insult to injury, you won't be able to claim a tax loss until the administrators issue a written declaration. Invariably that will be some years after the company disappears from the ASX (ASX: ASX).

So how can you avoid companies that might be candidates for administration?

Here's a simple number you can calculate. I don't make any claims about its predictive power, other than having observed the relationship over a long period of investing. But observation can be a useful tool, and this is one ratio I use regularly.

Simple calculation

It's very simple to calculate, being net debt to market capitalisation. If the ratio is greater than 1.0, that's when you should really start to worry. Let's use the latest accounts of Slater & Gordon (ASX: SGH) as an example (head to the balance sheet on page 5 of the 'Half-Year Financial Report' released on 29 February).

Net debt is calculated as 'Short-term borrowings' plus 'Long-term borrowings' minus 'Cash'. Using the numbers on page 5 of the accounts, Slater & Gordon's net debt at 31 December 2015 was $4.0m $789.2m - $51.9m = $741.3m. The company's market capitalisation today is $115m.

The net debt to market capitalisation ratio is therefore $741m to $115m, or 6.4 times.

On the face of it, this ratio implies Slater & Gordon is in dire straits. Of course, that much should already be clear from the statement that the company is 'working cooperatively with its banking syndicate'.

What the ratio means is that Slater & Gordon's net borrowings exceed its market capitalisation by 6.4 times. If the company was able to raise capital at its current share price (which wouldn't be feasible), it would need to conduct a 6.4:1 entitlement issue.

Risks high

A capital raising (or 'recapitalisation') of that size is extremely rare. When a company's net debt exceeds its market capitalisation by this magnitude, the risk of administration is extremely high. Slater & Gordon is a prime candidate for administration – and probably sooner rather than later.

There's also one other thing the net debt to market capitalisation ratio is good for – flagging a potential capital raising (or major asset sale). Plummeting share prices driven by solvency concerns tend to make directors nervous – and nervous directors usually prefer to raise capital or sell assets than risk insolvency.

Next time you're thinking 'surely this stock can't fall any further', calculate the net debt to market capitalisation ratio. If it's much higher than 1.0, watch out. Zero could end up being the final destination.

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