For an investor, there are two key questions to answer:
- How do you find warning signs of a company that could declare bankruptcy?
- If you own shares of a company that has declared bankruptcy, what are your options?
1. How to Find Warning Signs?
Typically, a publicly traded company will exhibit several signs of distress well in advance of declaring bankruptcy. Significant and persistent declines in reported earnings and revenues, failure to raise needed investment capital, credit rating downgrades, and other company-specific events can indicate the company is experiencing severe problems.
Of course, any of these occurrences would warrant a reevaluation of the company to determine if you still want to bear the risk and if it aligns with your investment strategy.
If you own and have decided to hang onto the shares of a company that is exhibiting these signs, but you remain concerned about the possibility of bankruptcy, one tool that provides an easy-to-assess output is the Altman Z-score. This score estimates the probability of bankruptcy using multiple financial ratios to assess a company's liquidity, profitability, leverage, and activity. The higher a company's Z-score, the less likely it is to declare bankruptcy in the near future, and the lower a company's Z-score, the more likely it is to declare bankruptcy. You may be able to find this information in financial reporting databases.
In next blogpost, we will discuss what options do you have if a company declared bankruptcy?