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Bankruptcy


Bankruptcy of Listed Companies

Bankruptcy of Listed Companies; picture of a road sign with green background with the words bankruptcy questions written on it in large white capital letters

A company faces bankruptcy when it can no longer pay its expenses since it effectively has no working capital left and its long-term liabilities are reaching its total assets value. The company's revenue is insufficient to cover its expenses. The Z-score which measures the probability of bankruptcy is usually very low and may even be negative.

Bankruptcy is the end result for a financially distressed company. Unfortunately for the stockholders this means loss of ownership of the company and their invested capital is basically lost. Bondholders are also affected and usually receive very little if any of the bonds face value and their invested capital is also mostly lost.

When a U.S. listed company can no longer pay its debts, management files for bankruptcy protection through the U.S. Federal Bankruptcy Court. There are two different types of bankruptcy proceedings that can be filed under the U.S. Bankruptcy Code. These are chapter 7 and chapter 11 and they have different outcomes for the company and its stockholders.

Which ever chapter a company files for, the bankruptcy court requires the creditors to agree that it would the most appropriate outcome for them. The creditors' main interest is in receiving the highest dollar rate of what is owed to them.

Chapter 7 Bankruptcy

The main reason management files for chapter 7 bankruptcy protection is when the company's liabilities are greater than its assets and the company has no hope of continuing its business operations. The creditors will likely agree and the bankruptcy court will assign a trustee.

Chapter 7 bankruptcy results in the company being liquidated with all its assets sold off to pay its creditors. If there are insufficient proceeds any remaining debt owed to creditors is null and void. There is no further claim by creditors and the company ceases to exist.

Creditors include secured creditors, unsecured creditors and bondholders. Under the bankruptcy code there is a hierarchy of creditors' claims as follows:

Hierarchy of creditors' claims:

  1. Secured creditors have priority. These are creditors who already have claims over assets (such as real estate) in the event of default. Proceeds from the company's liquidation are used to pay secured creditors first. If there are insufficient proceeds to cover all the secured creditors then they are all paid a pro rata rate.
  2. Unsecured creditors are next in line if there are any proceeds remaining. These are creditors who have provided funding or goods based on good faith that they will be paid. If there are any proceeds remaining then the unsecured creditors are paid. If there are insufficient proceeds to cover all the unsecured creditors then they are all paid a pro rata rate.
  3. Bondholders are next in line there are any proceeds remaining. Bonds are loans to the company and if there are any proceeds remaining then the bondholders are paid. If there are insufficient proceeds to cover all the bondholders then they are all paid a pro rata rate.

After all the creditors have been paid, if there are any proceeds remaining from the company's liquidation then the excess is returned to the stockholders on a pro rata rate. The preferred stock is paid first and any remaining funds is then paid to the common stockholders.

Usually companies file for chapter 7 bankruptcy protection when their liabilities exceed their assets and as such there is normally no excess left over for the stockholders. Thus the stockholders normally do not receive anything back from their invested capital.

Bankruptcy of Listed Companies; picture of a sheets of paper with legal document for the petition to file for bankruptcy for a company in a court room

Chapter 11 Bankruptcy

Management normally files for chapter 11 bankruptcy protection when the company's liabilities are less than its assets and the company has a good chance of continuing its business operations. The main reason creditors agree to this filing is when the outcome will provide a higher dollar return in recovering what's owed to them

The company outlines a plan to reorganize its business operations and a repayment plan is worked out to the creditors' satisfaction. The creditors agree to provide the company with interim relief from their claims and the plan is lodged with the bankruptcy court for approval.

The company cannot make any acquisitions or sell any part of its business or sell any assets while under chapter 11 bankruptcy protection. The company can only perform its normal business operations.

Chapter 11 is more common than chapter 7 with management maintaining control of the company and stockholders retaining ownership while under bankruptcy protection. However in most cases the company will no longer comply with the listing requirements for NYSE or NASDAQ and the company will likely be delisted. The company might be then listed on an over-the-counter market like the OTC Bulletin Board or the Pink Sheets. If the company is not listed then the stockholders cannot sell their shares other than with a private transaction. Bear in mind that a company under chapter 11 bankruptcy protection is almost worthless from an investment point of view.

Some companies will come out of chapter 11 bankruptcy and continue to operate as a profitable business. This is might happen when a company issues new stock as part of its reorganization plan to finance its operations. The reorganization plan may issue new stock to its creditors and it may cancel the existing shares once the chapter 11 is completed.

Even if the existing shares are not canceled, the new stock issued may have substantially more shares than the existing shares. Thus the existing shares may be diluted to such an extent that they have very little equity per share value, making them almost worthless even if the company does manage to operate profitably in the future.

The newly issued stock has a different ticker code to the existing stock and they are not interchangeable. The existing stock is given a new ticker code while the company is under chapter 11 bankruptcy protection (assuming the company is still listed). The newly issued stock does not trade until the company comes out of bankruptcy.

The end result is that even if the company operates profitably after it emerges from bankruptcy, the original shares either no longer exists of if they do then they are heavily diluted. The best case is that the existing shares are worth very little and they are not the same shares as the newly issued stock.

If the company does not operate profitably and the creditors are not receiving their agreed payments as specified in the repayment plan, then the Chapter 11 bankruptcy protection will be converted to a Chapter 7 and the company will be liquidated.

Bankruptcy and the Z-score

The likelihood of a company going bankrupt

Bankruptcy and the Z-score; picture of an animated man sitting on top of a sign saying bankrupt for z score written in large red font in capital letters

A company files for bankruptcy protection when it can no longer pay its expenses since it effectively has no working capital left and cannot raise the funds it needs to continue with its operations.

While there are speculative investing strategies which specifically deal with buying bankruptcy companies, these are best left to the professionals or at least the experienced investor. Famous investors like Benjamin Graham made good use of these hedge fund tactics but they are dangerous for the average investor.

As a general rule, buying while companies under bankruptcy protection is something that is best avoided as the average investor is usually left with nothing or at best very little. Bankruptcy is the end result for a financially distressed company and unfortunately for the stockholders this usually means loss of ownership of the company along with losing their invested capital.

Bankruptcy can result in either the company being liquidated with all its assets sold off to pay its creditors or the company's ownership is effectively handed over to its creditors who allow the company to continue to operate in order to recoup their debts. In the first case once all the creditors are paid and if there are funds left over then the stockholders' receive the balance. If there is no surplus then the stockholders' entire investment is lost. The same applies if the company is handed over to the creditors.

The likelihood of a company ending up in bankruptcy can be determined with a calculation known as the Z-score.

The Z-score was devised by Edward Altman who was a Professor of Finance and the formula utilizes items taken from the income statement and from the balance sheet statement. There are two versions of the Z-score depending on the industry group. The original version was specifically intended for manufacturing companies and a newer version which is more versatile and includes non-manufacturing companies. However neither version is suitable for financial companies.

Original Z-score

The original Z-score was devised for manufacturing companies with high levels of hard assets. Their revenue is largely dependant on their assets such as plant and machinery.

The Z-score is calculated from five ratios as follows:

Z-score calculation:

X1  =  Working Capital / Total Assets

X2  =  Retained Earnings / Total Assets

X3  =  Earnings Before Interest and Tax / Total Assets

X4  =  Market Value of Equity / Total Liabilities

X5  =  Revenue / Total Assets

Working Capital  =  Current Assets - Current Liabilities

Market Value of Equity  =  Stock price x Diluted shares outstanding

Z-score  =  (1.2 * X1) + (1.4 * X2) + (3.3 * X3) + (0.6 * X4) + X5

The Z-score provides a probability of a company becoming bankrupt within two years and the bankruptcy risk is broadly classified into three risk categories as follow:

Z-score probability of bankruptcy:

  • Low risk: If Z-score greater than 3.0
  • Moderate risk: If Z-score between 1.8 and 3.0
  • High risk: If Z-score less than 1.8

The Z-score can even be negative and this indicates a very high risk of bankruptcy. Basically the higher the Z-score then the lower the bankruptcy risk. Conversely the lower the Z-score then the higher the bankruptcy risk.

Example: A speculative manufacturing company has a stock price of $10 and 30m diluted shares outstanding and has the following balance sheet items; Current Assets of $60m, Current Liabilities of $40m, Total Assets of $180m, Total Liabilities of $70m and Retained Earnings of $100m. The income statement items are Revenue of $50m and Earnings before Interest and Tax of $15m.

The Z-score is calculated as follows:

Working Capital = 60 - 40 = $20m

Market Value of Equity = 10 * 30m = $300m

X1 = 20 / 180 = 0.11

X2 = 100 / 180 = 0.56

X3 = 15 / 180 = 0.08

X4 = 300 / 70 = 4.29

X5 = 50 / 180 = 0.28

Z-score  =  (1.2 * 0.11) + (1.4 * 0.56) + (3.3 * 0.08) + (0.6 * 4.29) + 0.28  =  4.0

With a Z-score of 4.0 this company is a low bankruptcy risk since the Z-score is greater than 3.0.

Revised Z-score

The newer version of the Z-score is used for today's market. It does not use Revenue or Market Value of Equity but instead uses Stockholders' Equity. This version is more general and is intended for the broader market - not just manufactures, but it is not suited to financial companies. The Z-score is calculated from four ratios as follows:

Z-score calculation for general companies:

X1  =  Working Capital / Total Assets

X2  =  Retained Earnings / Total Assets

X3  =  Earnings before Tax and Interest / Total Assets

X4  =  Stockholders' Equity / Total Liabilities

Working Capital  =  Current Assets - Current Liabilities

Z-score  =  (6.56 * X1) + (3.26 * X2) + (6.72 * X3) + (1.05 * X4)

The Z-score provides a probability of a company becoming bankrupt within two years and the bankruptcy risk is broadly classified into three risk categories as follow:

Z-score probability of bankruptcy for general companies:

  • Low risk: If Z-score greater than 2.6
  • Moderate risk: If Z-score between 1.1 and 2.6
  • High risk: If Z-score less than 1.1

The Z-score can even be negative and this indicates a very high risk of bankruptcy. Basically the higher the Z-score then the lower the bankruptcy risk. Conversely the lower the Z-score then the higher the bankruptcy risk.

Example: A speculative non-manufacturing company has the following balance sheet items; Current Assets of $100m, Current Liabilities of $90m, Total Assets of $200m, Total Liabilities of $180, Retained Earnings of $2m and a Stockholders' Equity of $20m. From the income statement the Earnings before Interest and Tax is $1m.

The Z-score for general companies is calculated as follows:

Working Capital = 100 - 90 = $10m

X1 = 10 / 200 = 0.05

X2 = 2 / 200 = 0.01

X3 = 1 / 200 = 0.005

X4 = 20 / 180 = 0.11

Z-score  =  (6.56 * 0.05) + (3.26 * 0.01) + (6.72 * 0.005) + (1.05 * 0.11)  =  0.5

With a Z-score of 0.5 this company is a high bankruptcy risk since the Z-score is less than 1.1.

Summary

The Z-score is merely a probability indicator and any company can be a bankruptcy risk in the future even if it is a low probability now. Also some companies end up in bankruptcy will little advanced warning.

The Z-score can also indicate a high probability of bankruptcy, but the company never goes into bankruptcy.

The indicator is especially useful for investing strategies involving speculative stocks which can help investors avoid the high risk stocks. The Z-score is only a probability and not a certainty so there are no guarantees, but at least the probability of a company with a high Z-score not going into bankruptcy is on the side of the speculative investor.

Some high risk speculative trading strategies specifically look for financially distressed stocks that are not under bankruptcy protection. These speculative strategies utilize short selling tactics and the Z-score is a convenient probability indicator for locating stocks with a low or even a negative Z-score as these stocks are a high probability for bankruptcy with two years.

While the Z-score is a useful indicator, it should be used in conjunction with fundamental analysis techniques such as financial ratio analysis in order to determine whether a company is fundamentally sound or not.

Buying Stocks

while in Bankruptcy

Buying Stocks while in Bankruptcy; picture of a road sign with triangle shape with bankruptcy written on it with exclamation mark in large white capital letters on a red background

Investors need to be clear on what bankruptcy means

Investing in a company while they are in bankruptcy proceedings tends to be a popular strategy. The stock price is only small fraction of what it used to be and some company's come out of bankruptcy as profitable companies with their stock prices returning to their former levels.

This gives stock investors the impression that if they buy stock at bankrupt levels that they can make a fortune if the company regains its previous profitability and the downside is limited to only a few cents.

This bankruptcy strategy is typically promoted through internet chat rooms, message boards and newsletters.

In principle this sounds like a good investing strategy but there are several issues which investors need to be aware of. There are certain situations where this highly speculative strategy works and in most other cases it does not work at all.

The first thing stock investors need to be aware of is Chapter 11 Bankruptcy Protection for U.S. companies.

Chapter 11 Bankruptcy Protection

Buying common stock in companies while under chapter 11 bankruptcy protection is pointless and is virtually guaranteed to lose the investors entire invested capital. Even buying preferred stock is ultra high risk. Buying corporate bonds at a sufficiently cheap price has a chance of being a profitable speculative investment as the bondholder is a creditor rather than an owner. This is a high risk strategy used by hedge funds.

What investors need to be aware of with chapter 11 bankruptcy is that the company is usually handed over to the creditors via newly issued stock. The purpose of this is to allow the creditors to recoup the monies owed to them. They do this as an alternative to liquidating the company under chapter 7.

While the new stock is issued to the creditors, the old stock is actually renamed with a different ticker symbol to denote that it is a company under chapter 11 bankruptcy protection. The stock is normally delisted from NYSE or NASDAQ and can be listed on an over-the-counter market such as the OTC Bulletin Board or the Pink Sheets.

Investors are frequently caught out since their

original stock is relisted on an OTC market

Should the company come out of chapter 11 bankruptcy protection profitably, the stock price that is shown is for the newly issued stock, which only trades after the company has exited bankruptcy.

The old stock which is what the speculative investors bought is usually canceled after being listed on an OTC market. Under some circumstances the old stock is not canceled but it is heavily diluted. Even if the old stock is not canceled it is not the same as the newly issued stock and they have different ticker codes.

The end result is that the creditors end up owing most and usually all of the company should it emerge from bankruptcy. Any stock bought by investors either no longer exists or is only worth a fraction of the newly issued stock.

Buying Stocks while in Bankruptcy; picture of a road sign stating bailout for company facing bankruptcy written in large black letters against a red background

Without Bankruptcy Proceedings

Bankruptcy is the formal approach for companies who can no longer pay its debts. Sometimes a company can work out a plan with its creditors without going through the bankruptcy court proceedings.

If the company's management and its creditors can agree on a solution, then there is no bankruptcy proceeding and chapter 11 does not apply. In this case the stockholders still own the company but their stock may be diluted as the company may issue stock to the creditors as compensation for monies owed to them, but the stock issued is the same as the investors stock.

Usually the stock price of these companies is driven very down to low levels due to the company's poor financials and can be well below tangible book value. The Z-score which measures the probability of bankruptcy is usually very low and may even be negative. Buying the company's bonds at depressed prices also has a better chance of success.

Speculative investing with these financially distressed companies is still high risk but at least there is a chance that the investor can make a profit with the common stock if the company manages to return back to a profitable business. In this case the investors' stock has not changed (unlike that with the chapter 11 bankruptcies) and the common stock can be sold if the stock price returns to its former levels. The risk is that the creditors are not satisfied with the amount of monies being recouped and the company ends up filing for bankruptcy protection under either chapter 7 or chapter 11.

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