Guarantee Ratio: The Formula That Anticipates Bankruptcies

How to Know if a Company Can Pay Its Debts? Bankers and investors rely on a simple yet devastatingly effective indicator: the guarantee ratio. This number reveals whether a company’s equity is sufficient to cover all its obligations or if it is heading toward financial collapse.

What Does the Guarantee Ratio Really Tell Us?

The guarantee ratio measures a company’s long-term repayment capacity. Unlike the (short-term liquidity ratio), this metric examines the entire debt structure regardless of when it matures.

The formula is straightforward:

Guarantee Ratio = Total Assets / Total Liabilities

If a company has $100 million in assets and $40 million in debts, its ratio is 2.5. But what does that really mean?

Interpreting the Numbers: What Banks Look For

When you apply for a long-term loan (machinery, real estate, industrial leasing), the bank calculates your guarantee ratio before approving anything. Here’s what they look for:

Ratio below 1.5: Danger zone. The company has excessive debt and a high risk of insolvency.

Ratio between 1.5 and 2.5: Safe zone. Normal range for most solvent companies.

Ratio above 2.5: Possible inefficiency. Too many underutilized assets or insufficient financing.

Real Cases: When Numbers Don’t Lie

Tesla vs Boeing: A revealing contrast

Tesla showed a ratio of 2.259 in its latest reports. Analysts labeled it as “overvalued,” but its business model (intensive technology research) requires equity capital rather than debt. It’s a justified overvaluation based on its strategy.

Boeing, in contrast, had a ratio of 0.896. That means liabilities exceeded assets. Why? The pandemic reduced aircraft demand while debts remained intact.

The Revlon Lesson:

Cosmetics company Revlon declared bankruptcy recently. As of September 2022:

• Total assets: $2.52 billion
• Total liabilities: $5.02 billion
• Guarantee ratio: 0.50

That 0.50 was a death sentence. The company literally didn’t have enough assets to cover half of its debts. And it worsened each quarter: fewer assets, more debts.

Why This Ratio Is Devastatingly Accurate

Three key advantages make the guarantee ratio a reliable tool:

1. It works equally for all companies, from startups to multinational corporations. Size doesn’t matter.

2. It is predictable. All bankruptcies were preceded by a compromised guarantee ratio. It’s almost a leading indicator.

3. It complements other ratios well. Combined with the liquidity ratio, it identifies whether a company has short-term problems or structural insolvency.

The Trap: Not Everything Depends on a Number

Here’s the crucial part: a high guarantee ratio doesn’t always mean health. Tesla exceeded 2.5 but remained profitable because its (green technology) industry justifies that structure.

You need three things to interpret it correctly:

1. The historical trend of the ratio. Is it improving or worsening?
2. The sector context. Airlines naturally have higher ratios than tech companies.
3. The business model. R&D companies need more capital; service companies, less.

How to Calculate Step-by-Step

Getting a guarantee ratio is accessible even without advanced accounting knowledge:

1. Find the company’s published balance sheet
2. Locate “Total Assets”
3. Locate “Total Liabilities”
4. Divide assets by liabilities
5. Compare the result to 1.5-2.5

For example, if a company reports $500 million in assets and $250 million in liabilities: 500/250 = 2.0. It’s in the safe zone.

The Time Factor: Why Banks Require It

Banks and creditors distinguish three risk scenarios:

• Annual credit line: Needs a good liquidity ratio (the bank renews annually and monitors short-term)
• 5-year loan: Requires a solid guarantee ratio (needs long-term protection)
• Factoring or confirming: Demands a very robust guarantee ratio (the bank guarantees your solvency to third parties)

The Important Conclusion

The guarantee ratio is the smoke detector of corporate financial health. It’s not perfect, but it’s extraordinarily effective.

If you invest in a company or negotiate with one, review its historical trend of this ratio. A declining number is a red flag that precedes disaster. Revlon proved it. Boeing also learned it.

The combination of a stable or increasing guarantee ratio with a healthy liquidity ratio is your best compass to identify well-managed companies versus those building castles on quicksand.