What Is Bankruptcy Risk?

Bankruptcy risk, or insolvency risk, is 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 before making equity or bond investment decisions. Firms with high risk of bankruptcy may find it difficult to raise capital from investors or creditors.

Credit agencies such as Moody's and Standard & Poor's attempt to assess bankruptcy risk by producing bond ratings as well as rating the issuers.

Key Takeaways

  • Bankruptcy risk refers to the chance that a company will be unable to pay its debts, rendering it insolvent; often caused by inadequate cash flows or excess costs.
  • Investors and analysts can measure solvency with liquidity ratios, such as the current ratio, which compares current assets to current liabilities.
  • When a public company files for bankruptcy, it can reorganize, close its operations, or sell off its assets and use the proceeds to pay off its debts.

Understanding 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, even though the value of its assets exceeds the value of its liabilities. A firm becomes legally insolvent if the value of its assets is less than the value of its liabilities. A firm is finally considered to be bankrupt if it is unable to pay its debts and files a bankruptcy petition.

Companies can have varying degrees of insolvency that stretch all the way from "technically insolvent" to "bankrupt."

How to Determine Bankruptcy Risk

Solvency is often measured with a liquidity ratio called the current ratio, which compares 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. Some, for example, 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.

How do you know if a company is at risk of going bankrupt? The following are often signs of trouble:

  • Dwindling cash and/or losses, especially if they represent a trend
  • Abrupt dismissal of the company auditor
  • Dividend cuts or the elimination of dividends
  • Departure of senior management
  • Insider selling, especially large or frequent transactions following negative news
  • Selling off a product line to raise cash
  • Cuts in perks like health benefits or pensions

How Companies Reduce Insolvency Risk

No company becomes insolvent overnight. If it looks like your business is headed in that direction, take steps to protect it.

  • Focus on cash flow. Among other actions, this may involve invoicing promptly, recovering debts, renegotiating credit limits, renegotiating contracts with suppliers, selling assets (if necessary), and reducing the amount of cash tied up in stock.
  • Reduce business expenses. Possibilities include cutting advertising and/or research and development, paying off debts earlier to lower interest on debt, reducing staff overtime, delaying the purchase of new or leased equipment.
  • Keep your creditors in the loop. Discuss any problems you are having with payments and be ready to negotiate and compromise.
  • Get good financial and legal advice. Consult the company's accountant and lawyer, who should already be familiar with your business.

Bankruptcy Protection

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.