Why does this happen?
Because profitability does not guarantee stability.
The Profit & Loss statement reflects past performance. Stability ratios, derived from the Balance Sheet, indicate whether a business can sustain itself in the future. A company may be profitable but fail due to poor liquidity, excessive leverage, or weak capital structure.
To ensure long-term survival, businesses must closely monitor the following five critical stability ratios.
1. Current Ratio (The 2:1 Rule)
Formula:
Current Assets ÷ Current Liabilities
Explanation:
The current ratio measures a company’s ability to meet its short-term obligations using short-term assets. It answers a fundamental question: Does the business have enough resources to cover its immediate liabilities?
A commonly accepted benchmark is 2:1, meaning the company has twice the assets required to meet its short-term commitments.
Why It Matters:
A declining current ratio signals potential cash flow stress and operational risk. Even profitable businesses can face disruptions if they cannot meet day-to-day obligations.
2. Liquidity Ratio (The Acid Test)
Formula:
(Current Assets – Inventory) ÷ Current Liabilities
Explanation:
This ratio excludes inventory because inventory is not always readily convertible into cash. It evaluates whether the business can meet its short-term liabilities using only liquid assets such as cash, bank balances, and receivables.
The ideal benchmark is 1:1.
Why It Matters:
Inventory depends on market demand and sales cycles. A strong liquidity ratio ensures the company can meet obligations without relying on uncertain asset conversions.
3. Proprietary Ratio (Skin in the Game)
Formula:
(Capital + Reserves) ÷ Total Assets
Explanation:
The proprietary ratio indicates how much of the company’s assets are financed by owners’ funds versus external liabilities.
Why It Matters:
A higher proprietary ratio reflects stronger financial stability and owner commitment. From a lender’s perspective, it reduces risk, as the promoters have substantial capital invested in the business.
4. Debt–Equity Ratio
Formula:
Debt ÷ Equity
Explanation:
This ratio assesses the balance between borrowed funds and shareholders’ funds.
Key Principle:
Debt itself is not a problem—unproductive debt is. When borrowed funds generate returns higher than their cost, leverage works in favor of the business.
Typical Banking Norms:
- Small and medium enterprises: up to 3:1
- Large corporations: approximately 1:1
Excessive leverage increases vulnerability during economic downturns, regardless of profitability.
5. Repayment Coverage Ratio
Formula:
Funds Available for Repayment ÷ Loan Installments Due
Explanation:
While interest coverage ratios measure the ability to service interest, the repayment coverage ratio evaluates whether the company can repay both interest and principal.
Why It Matters:
A business may service interest comfortably but still struggle to repay principal amounts, leading to refinancing pressure and long-term financial strain.
Conclusion
Profitability reflects success.
Stability ensures survival.
A strong bottom line is important, but it does not tell the complete story. Businesses that ignore balance sheet strength expose themselves to unnecessary risk.
Profit makes a company look good. Stability allows it to endure.
To build a business that lasts, look beyond profits—and pay close attention to financial stability.