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What is a Bankruptcy Risk?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 10 September 2016
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    2003-2016
    Conjecture Corporation
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Also known as insolvency risk or default risk, bankruptcy risk is the potential for a debtor to become unable to meet his or her debt obligations. Lenders assess this type of risk as part of the process of considering an application for a loan, a line of credit, or any other type of financial assistance that involves repayment. Lenders also utilize a similar approach when evaluating loan applications from businesses, taking into consideration every factor that relates to the ability of the company to repay that loan within the terms and conditions noted in the loan contract.

Along with loans and the extension of credit lines, investors will also look closely at bankruptcy risk when considering the possibility of investing in a business venture. For example, an angel investor who is thinking about backing a new business venture will look closely at the way the business is structured. He or she will also consider the background and experience of the owners, and the potential for success that the business demonstrates, based on the goods or services that will be offered to consumers. Should the angel investor determine there is a solid market for those products, that the company has a well-planned and realistic business model, and that the owners have the expertise and background necessary for success, he or she is likely to consider the level of risk acceptable and choose to invest in the venture.

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Many of the same criteria that are used to determine a credit score also go into the calculation of bankruptcy risk. The ratio of debt load to income is important, as this figure is a strong indicator of the debtor’s ability to repay the lender in a timely manner. Debtors who have relatively few financial obligations, and who are paying off those obligations on time without making late payments, are likely to be considered less of a risk. The demonstration of strong money management skills, and a reputation for honoring all contractual obligations is also a strong indication that the potential for the debtor to file a Chapter 11 or Chapter 7 bankruptcy action is remote, assuming there is no significant change in the debtor’s circumstances.

Another handy tool in assessing the bankruptcy risk associated with an established business is to consider the bond ratings prepared by agencies such as Standard & Poor’s, or Moody’s. These ratings are based on careful examination of the overall financial health of a business, and are especially helpful to investors. While helpful, it is important to realize that relying strictly on these ratings may or may not provide adequate information to make a final decision. For this reason, lenders should also consider data available from other sources before deciding if the loan applicant represents a low amount of bankruptcy risk.

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