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.

RELATED TERMS
  1. Accounting Insolvency

    A situation where the value of a company's liabilities exceeds ...
  2. Insolvency

    When an individual or organization can no longer meet its financial ...
  3. Cash Asset Ratio

    The current value of marketable securities and cash, divided ...
  4. Junior Security

    A security that ranks lower than other securities in regards ...
  5. Cash Available For Debt Service ...

    A ratio that measures the amount of cash a company has on hand ...
  6. Financial Risk

    The possibility that shareholders will lose money when they invest ...
Related Articles
  1. Small Business

    Taking Advantage Of Corporate Decline

    A bankrupt company can provide great opportunities for savvy investors.
  2. Financial Advisor

    Should You File For Bankruptcy?

    Find out how to determine whether this option will help or hurt your financial situation.
  3. Investing

    Financial Analysis: Solvency vs. Liquidity Ratios

    Solvency and liquidity are equally important for a company's financial health.
  4. Taxes

    Changing The Face Of Bankruptcy

    A 2005 law attempts to unmask fraudulent debtors and still save those who are struggling. Will it affect you?
  5. Taxes

    How To Survive A Bankruptcy Filing

    Learn how to make filing for bankruptcy less painful so you can successfully rebuild your financial life.
  6. Investing

    Understanding Leverage Ratios

    Large amounts of debt can cause businesses to become less competitive and, in some cases, lead to default. To lower their risk, investors use a variety of leverage ratios - including the debt, ...
  7. Investing

    Financial Ratios to Spot Companies Headed for Bankruptcy

    Obtain information about specific financial ratios investors should monitor to get early warnings about companies potentially headed for bankruptcy.
  8. Taxes

    7 Decisions That Lead To Bankruptcy In The UK

    In the past three years, personal bankruptcies have been on the rise throughout the U.K. Here's how it happens.
  9. Personal Finance

    What You Need To Know About Bankruptcy

    Don't choose this last-resort option until you learn how it will affect your future.
RELATED FAQS
  1. What are the main benchmarks that track the forest products sector?

    Learn how the net debt to EBITDA ratio, EBITDA to interest ratio and debt to capital ratio financial benchmarks are used ... Read Answer >>
  2. What happens when a corporation declares bankruptcy?

    Understand what options are available to corporations under bankruptcy protection, and learn what takes place after bankruptcy ... Read Answer >>
  3. Can personal loans be included in bankruptcy?

    Read about debts that are dischargeable when filing for bankruptcy. Learn about how personal loans are treated when filing ... Read Answer >>
  4. On which financial statements does a company report its long-term debt?

    Discover which financial statements are used to report a company’s long-term debt, as well as how a company uses debt to ... Read Answer >>
  5. Are current assets liquid or capital?

    Take a deeper look at liquid current assets for businesses and individuals, and learn how they differ from other types of ... Read Answer >>
Hot Definitions
  1. Leverage Ratio

    Any ratio used to calculate the financial leverage of a company to get an idea of the company's methods of financing or to ...
  2. Two And Twenty

    A type of compensation structure that hedge fund managers typically employ in which part of compensation is performance based. ...
  3. Market Capitalization

    The total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying ...
  4. Expense Ratio

    A measure of what it costs an investment company to operate a mutual fund. An expense ratio is determined through an annual ...
  5. Mezzanine Financing

    A hybrid of debt and equity financing that is typically used to finance the expansion of existing companies. Mezzanine financing ...
  6. Long Run

    A period of time in which all factors of production and costs are variable. In the long run, firms are able to adjust all ...
Trading Center