DEFINITION of 'Bankruptcy Risk'

Bankruptcy risk refers to the likelihood that a company will be unable to meet its debt obligations. It is the probability of a firm becoming insolvent due to its inability to service its debt. 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.

Bankruptcy risk is also called insolvency risk.

BREAKING DOWN 'Bankruptcy Risk'

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. In essence, 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 ratio 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, some consider 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. Insolvency

    Insolvency is a situation in which an individual or organization ...
  2. Accounting Insolvency

    Accounting insolvency refers to a situation where the value of ...
  3. Voluntary Bankruptcy

    Voluntary bankruptcy is a type of bankruptcy where an insolvent ...
  4. Bankruptcy Financing

    Bankruptcy financing is financing arranged by a company while ...
  5. Debt Restructuring

    Debt restructuring is a method used by companies with outstanding ...
  6. Debt Loading

    Debt loading occurs when one spends case reserves, maxes out ...
Related Articles
  1. Taxes

    How To Survive A Bankruptcy Filing

    Learn how to make filing for bankruptcy less painful so you can successfully rebuild your financial life.
  2. 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.
  3. 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.
  4. Investing

    5 Energy Companies Crushed by Low Oil in 2016

    Oil companies globally are at risk of slipping into bankruptcy, and many of these businesses could disappear, leaving the sector worse off than in 2008.
  5. Taxes

    Bankruptcy Filing Changes That Could Affect You

    When the economy is down, more people file for bankruptcy. Make sure you know about the changes that have been made to this process.
  6. 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.
  7. Taxes

    How To Survive Bankruptcy

    Bankruptcy is not the end of the world. You can survive it and come out on the other side more financially solid.
  8. Taxes

    How to Hire a Bankruptcy Lawyer

    How do you find the right bankruptcy lawyer? What you should look for to determine the right attorney for you.
  9. Insurance

    Personal Bankruptcies Cut Almost in Half After Obamacare

    Access to health insurance many have saved many Americans from going broke.
  10. Small Business

    7 Bankrupt Companies That Came Back

    Bankruptcy is often the end of a company – until it isn't.
RELATED FAQS
  1. What happens to a company's stock when it goes bankrupt?

    Shareholders may be entitled to a portion of the liquidated assets in the wake of a company bankruptcy, but the stock will ... Read Answer >>
  2. 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 >>
Trading Center