DEFINITION of 'Bankruptcy Risk'

The possibility that a company will be unable to meet its debt obligations. Bankruptcy risk describes the likelihood that a firm will become insolvent because of its inability to service its debt. A firm can fail financially because of cash flow problems resulting from inadequate sales and high operating expenses. To address the cash flow problems, the firm might increase its short-term borrowings. If the situation does not improve, the firm is at risk of insolvency or bankruptcy. Many investors consider a firm's bankruptcy risk prior to making equity or bond investment decisions. Agencies such as Moody's and Standard & Poor's attempt to assess risk by giving bond ratings. Also called "insolvency risk."

BREAKING DOWN 'Bankruptcy Risk'

Insolvency occurs when a firm cannot meet its contractual financial obligations as they come due. Obligations might include interest and principal payments on debt, payments on accounts payable and income taxes. More specifically, a firm is technically insolvent if it cannot meet its current obligations as they come due, despite the value of its assets exceeding the value of its liabilities. A firm is legally insolvent if the value of its assets is less than the value of its liabilities. A firm is bankrupt if it is unable to pay its debts and files a bankruptcy petition.

Solvency is measured with a liquidity ration called the "current ratio," a comparison between current assets (including cash on hand and any assets that could be converted into cash within 12 months such as inventory, receivables and supplies) and current liabilities (debts that are due within the next 12 months, such as interest and principal payments on debt serviced, payroll and payroll taxes). There are many ways to interpret the current ratio. For example, the textbook "Contemporary Financial Management" considers a 2:1 current ratio as solvent, showing that the firm's current assets are twice its current liabilities. In other words, the firm's assets would cover its current liabilities about two times.

When a public company is unable to meet its debt obligations and files for protection under bankruptcy, it can reorganize its business in an attempt to become profitable, or it can close its operations, sell off its assets and use the proceeds to pay off its debts (a process called "liquidation"). In a bankruptcy, the ownership of the firm's assets transfers from the stockholders to the bondholders. Because bondholders have lent the firm money, they will be paid before stockholders, who have an ownership stake.

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