What is Bankruptcy Risk?
Bankruptcy risk, also known as insolvency risk, represents the likelihood that a company will fail to meet its debt obligations, leading to insolvency. This risk reflects the probability that a firm will become unable to service its debt, which can affect investment decisions. Investors often evaluate a company’s bankruptcy risk before making decisions on equity or bond investments. Companies with high bankruptcy risk may struggle to attract capital from investors or creditors.
In Australia, filing for bankruptcy can be every bit distressing. AFSA reported in May 2024 that the insolvencies filed in Q1 2024 numbered 2,981, 19.5 per cent higher from the same period a year ago at 2,494. Of those filings, 25.4 per cent were identified as business-related personal insolvencies.
Equifax added that Australia is already in the midst of a so-called “insolvency tsunami,” with insolvencies in the country up 145.7 per cent from where they were in 2022. They evaluated that construction and hospitality businesses were at the most risk of shutting down.
Key points:
- Bankruptcy risk indicates the probability that a company will be unable to fulfil its debt obligations, potentially leading to insolvency. This situation often arises from inadequate cash flows or excessive costs.
- Investors and analysts assess solvency through liquidity ratios, such as the current ratio, which compares current assets to current liabilities.
- When a public company files for bankruptcy, it may reorganise its operations, shut down, or liquidate assets to repay its debts.
Understanding Bankruptcy Risk
Financial failure within a company can stem from cash flow issues arising due to insufficient sales and elevated operational expenses. To tackle these cash flow challenges, the company might resort to increasing its short-term borrowings. Should this scenario persist, the company faces the looming threat of insolvency or bankruptcy.
In essence, insolvency unfolds when a company falls short of meeting its contractual financial commitments as they become due. These obligations encompass interest and principal repayments on debts, settlements on outstanding accounts, and income tax payments.
To delineate further, a company enters a state of technical insolvency if it cannot satisfy its current commitments when due, even if the value of its assets exceeds its liabilities. Legally, a company is deemed insolvent when the value of its assets falls below that of its liabilities. Ultimately, a company is declared bankrupt when it fails to settle its debts and files for bankruptcy.
Determining on Bankruptcy Risk
Solvent status is commonly assessed using a liquidity gauge known as the current ratio, comparing current assets (cash reserves and assets convertible to cash within a year, like inventory, accounts receivable, and supplies) against current liabilities (inclusive of debts due within the next 12 months, such as debt interest and principal payments, payroll, and payroll taxes).
Interpreting the current ratio varies widely. For instance, some view a 2:1 current ratio as indicative of solvency, as in that the value of a company’s current assets stand at twice the level of its current liabilities. Essentially, the company’s assets would cover its current liabilities around two times over.
Recognising signs of potential bankruptcy risk within a company involves considering various indicators:
- A diminishing cash position and/or consecutive losses, particularly if they reflect a continuing trend.
- Exits at the upper management, such as executives and the company auditor (who may have stepped down or was let go).
- Reductions in dividends or the complete cessation of dividend payouts.
- Insider selling activities, especially substantial or frequent transactions after some news.
- Selling off product lines to generate immediate cash.
- Cutbacks in employee benefits, such as superannuation contributions.
How Companies Reduce Insolvency Risk
Insolvency isn’t an abrupt occurrence for any company. If your business seems to be heading towards this scenario, it’s crucial to take emergency measures.
Prioritised cash flow
This may involve immediate actions such as promptly invoicing, recovering outstanding debts, renegotiating credit limits, revising supplier contracts, selling assets as required, and optimising stock inventory for improved liquidity.
Reduced expenses
Trim business expenditures by considering options like reducing advertising or research and development expenses, proactively settling debts to mitigate interest costs, curtailing staff overtime, and delaying new equipment purchases or leases.
Maintain open communication with your creditors
Discuss any payment challenges you’re encountering and be prepared to engage in negotiations and find amicable solutions.
Seek comprehensive financial and legal guidance
Consult with the company’s accountant and solicitor, or other professionals already acquainted with your business operations, to gain informed advice and strategies.
Bankruptcy Protection
If a publicly-traded company fails to meet debt commitments and seeks refuge through bankruptcy proceedings, it faces choices: restructuring its operations to strive for profitability or opting for closure and asset liquidation, with the proceeds programmed for settling debts. The Bankruptcy Act 1966 and its subsequent amendments are Australia’s main tool for governing resolutions under a bankruptcy .
During bankruptcy, the transfer of ownership for the company’s assets shifts from the shareholders to the bondholders. Given that bondholders extend loans to the firm, they receive priority in repayment before the shareholders, who hold an ownership interest in the company.
Conclusion
If your business is close to shutting down trading due to financial issues, there’s still time to avoid the threat. You can seek help to limit the damage.
DISCLAIMER: This article is for informational purposes only and does not replace official business advice. AVANTE PARTNERS has no relationships with any company or government body mentioned. Please consult a business coach and financial advisor.
