Which financial ratios best predict company distress?

Key ratios identified by research

Academic and practitioner studies converge on a small set of financial ratios that consistently signal elevated risk of corporate distress. Profitability measures such as earnings before interest and tax relative to total assets are foundational because sustained losses erode equity cushions. Leverage ratios, notably total liabilities to total assets and debt to equity, indicate how much financial burden a firm carries and how little margin it has for shocks. Liquidity ratios like the current ratio and quick ratio reveal short-term ability to meet obligations and are often the first warning signs of operational stress. Cash flow measures, especially operating cash flow relative to liabilities or assets, frequently outperform accrual-based profit metrics in the final months before default because they capture actual resource availability. Market-based indicators including market-to-book ratios and equity volatility add forward-looking information by reflecting investor expectations and are particularly useful for publicly traded firms.

Edward I. Altman of New York University Stern School of Business showed that combining several ratios produces stronger predictions than any single measure, leading to the widely used Z-score model that integrates working capital, retained earnings, operating profitability, market valuation, and sales efficiency. James A. Ohlson of New York University developed a complementary approach using logistic regression to combine firm size and accounting ratios into a probability of bankruptcy, demonstrating the value of multivariate models. John Y. Campbell of Harvard University and colleagues found that adding market variables improves prediction further, especially out of sample and in changing economic conditions.

Causes, relevance, and consequences

Ratios are indicators rather than causes, but they reflect underlying drivers of distress. High leverage often results from aggressive growth, cyclical downturns, or capital-intensive operations that suddenly lose revenue. Weak profitability and deteriorating cash flow may stem from competitive disruption, loss of key customers, or regulatory shifts. Liquidity shortfalls can be exacerbated by supplier withdrawal or tightening credit markets. These mechanisms show why ratios matter: they summarize operational, financing, and market positions that determine survival.

The consequences of firm distress extend beyond investors to employees, suppliers, and local communities. In regions dependent on a single major employer, corporate failure can lead to significant social and territorial disruption, including job losses and reduced local tax bases. Environmental considerations amplify stakes for resource-based firms where insolvency can delay remediation and transfer liabilities to governments or communities. Cultural and institutional differences also affect predictive performance; accounting quality, disclosure practices, and access to informal financing in emerging markets can weaken the signal carried by standard ratios and require localized model adjustments.

Practical application and limitations

For practitioners, the most effective screening uses a combination of profitability, leverage, liquidity, cash flow, and market indicators rather than reliance on a single ratio. Models must be calibrated to industry and jurisdiction to account for accounting treatment, business cycles, and cultural norms around risk-taking and creditor behavior. Even robust statistical models cannot foresee all idiosyncratic shocks, so ratio-based prediction should guide further analysis, monitoring, and contingency planning rather than serve as sole decision rules.