Posted in Finance, Accounting and Economics Terms, Total Reads: 520
Definition: Bankruptcy Risk
A risk that an individual or a company will not be able to meets its financial obligations like servicing its debts as they come due. Also known as insolvency risk or default. It is the probability of risk for the firm due to its counterpart going bankrupt or the likelihood of the firm going insolvent. A firm may not be able to meet its debt obligation because of inadequate cash flow, which can be caused be low sales and high operating expenses or by managing assets poorly. To manage the cash flow problem, the firm may increase its short term borrowing but if the situation remains the same, the risk of bankruptcy or insolvency is quite high.
Banks and investors assess Bankruptcy Risk before giving a loan or making equity or bond investments. Rating agencies also assess the risk by bond rating.
Insolvency occur when the company is not in a position to meet its obligation. Obligations can include interest on debt, account payable or income tax.
Technical insolvency occur when the firm cannot meet its current obligation despite assets being higher than liabilities. Accounting/ legal insolvency occurs when the value of firm's assets is lower than the value of its liabilities. Bankruptcy is when the firm the it is unable to pay its due and files a legal petition and all its financial affairs are in court's supervision.
Solvency can be measured by financial solvency ratios like, current ratio i.e current assets over current liabilities, quick ratio or acid test ratio. Bankruptcy risk sore can also be used, to indicate the likelihood of an individual or a company going bankrupt or to calculate bankruptcy risk.