I have been reviewing how banks assess the financial health of companies, and there is one indicator that’s really worth understanding: the collateral ratio. It’s one of those concepts that sounds complex but is quite straightforward once you break it down.

Basically, the collateral ratio tells you if a company has enough assets to cover all its debt. It’s not the same as the liquidity ratio, which only looks at short-term obligations. Here, we’re talking about seeing the full picture: can the company cover everything it owes, regardless of when it’s due?

The formula is simple: total assets divided by total liabilities. That’s it. You don’t need to be an accountant to figure it out. If you have access to the balance sheet, you have the numbers.

Now, what do the results mean? When you see a collateral ratio below 1.5, it’s a red flag. The company is loaded with debt, and the risk of bankruptcy is real. Between 1.5 and 2.5 is the normal range where most companies should be. But if it exceeds 2.5, it could indicate they’re wasting financing opportunities or simply not using their resources efficiently.

Let’s take Tesla as an example. Its numbers showed a collateral ratio around 2.26, which sounds high. But here’s the thing: tech companies need a lot of equity for research and development. If they relied on external debt for that, they’d have solvency problems. So, the business context matters.

Compare it with Boeing. During the COVID crisis, its collateral ratio plummeted because revenues fell but debt remained. That’s what happens when a sector collapses.

The clearest case I’ve seen is Revlon. In September 2022, before declaring bankruptcy, its collateral ratio was 0.50. It had $5 billion in debt but only $2.5 billion in assets. Impossible to get out of that. And it was getting worse each quarter because assets decreased while debt grew.

The important thing is not to look at the collateral ratio in isolation. Combine it with the company’s history, study how it moves within its sector, understand the business model. A high ratio for a tech startup is normal. The same ratio for a traditional company could be concerning.

This indicator is useful because it works equally well for large and small companies, is easy to calculate, and has proven to be reliable: almost all companies that went bankrupt previously had a compromised collateral ratio. If you combine it with other analyses, you have a pretty solid tool to evaluate the management quality of any company you’re considering investing in.