I have been reviewing how banks assess the financial health of companies and I came across something interesting: the collateral ratio is probably one of the most reliable indicators out there. It’s not magic, it’s pure mathematics, and I’ll explain it to you.

Basically, the collateral ratio measures whether a company has enough assets to cover all its debt. It sounds simple because it is. But here’s the important part: while other ratios like liquidity only look at what happens in the short term, this indicator gives you the full picture of the balance sheet. It tells you if the company would survive financially in the long run.

The formula is straightforward: total assets divided by total liabilities. That’s all. If you have the balance sheet numbers, you have the collateral ratio. That’s why banks use it so much. When they ask for a large loan for machinery or real estate, the first thing they look at is this ratio. If you’re requesting a one-year credit line, they care more about liquidity, but if it’s long-term, they go straight to the collateral ratio.

Now, how to interpret the ratio formula. If it’s below 1.5, the company is loaded with debt and the risk of bankruptcy is real. Between 1.5 and 2.5 is normal, the range where most healthy companies operate. Above 2.5 may mean they have too many assets that aren’t being efficiently financed, which is also inefficient.

I’ll give you two examples I saw analyzing balance sheets. Tesla showed a ratio of 2.259, indicating it could cover its debts without issue. Boeing, on the other hand, was at 0.896, clearly compromised. And of course, Boeing later had its post-COVID problems. The collateral ratio saw it coming.

The most brutal case was Revlon. As of September 2022, they had liabilities of 5.02 billion but only 2.52 million in assets. The collateral ratio turned out to be 0.5019. Basically, they were bankrupt before declaring bankruptcy. The indicator worked perfectly.

What I learned is that you can’t take the collateral ratio in isolation. You need to look at the company’s historical trajectory, understand its industry, its business model. A tech startup might have a high ratio because it invests heavily in research, but that’s normal in its sector. Revlon didn’t; Revlon was poorly managed.

If you combine this ratio with liquidity and understand the business context, you have a very powerful tool to evaluate where to invest. It’s one of those indicators that almost never fails. All the companies that went bankrupt previously had a compromised collateral ratio. So if you see red numbers in this indicator, better look elsewhere.