Bankruptcy is the ultimate risk in stock investing. In the current economic condition, it's a much higher risk than normal. Many companies that had very strong businesses at the beginning of 2020, quickly came into serious peril. All due to the complete halt of our economy.
Both the federal government and the Federal Reserve have reacted swiftly and decisively to try to keep companies afloat until the economy improves.
However we are likely to see an uptick in bankruptcies over the next 12 months. In fact, we’ve already seen a large increase in bankruptcy filings.
The American Bankruptcy Institute reported a 26% increase in filings in April from last year.
You might be holding shares in a company that's filed for bankruptcy. Or considering taking a position in a company that's recently filed thinking you might be able to make some easy money. Be aware that it's contingent on if the company survives.
The obvious question is what happens to my stocks if a company files for bankruptcy?
In this article, we’ll examine the different types of bankruptcy available to corporations and what each means to stockholders; as well as how to avoid companies that are in danger of filing for bankruptcy.
This might just save your butt from buying a stock that is in serious trouble. Bankruptcy stock can get you into trouble if you're not careful.
What is Bankruptcy?
- Bankruptcy is a legal process that is carried out in federal courts that allows businesses and individuals who are unable to repay their debts a way out while helping creditors collect at least part of what they are owed. We'll only focus on business bankruptcies here, but for more on fundamental analysis head here.
Prior to bankruptcy, debtors who couldn’t repay their creditors were sent to debtors’ prison. As you could imagine, it’s difficult to come up with money to repay someone while locked up in jail.
Modern bankruptcy laws in the US took a long time to come about. Bankruptcy laws were passed 3 times in the 1800s; and promptly repealed before the Bankruptcy Act of 1898 was passed and finally stayed on the books.
These laws were refined in acts passed in 1933 and 1934 during the economic tumult of the Great Depression.
In fact, many of the securities laws that still govern our public markets today were passed in those two years as well. Our live trading room will discuss things like different bankruptcy stock to look at.
In most cases, the debtor files the petition for bankruptcy to protect themselves from creditors. However, in rare cases, a creditor may file a petition with bankruptcy courts if they believe that if a business continues operations, they'll decrease their assets.
Creditors have rights to a company’s assets if payment arrangements aren't honored. This is why you might hear the phrase “bankruptcy protection.” More on that in a moment.
1. What Happens to Stock in Chapter 7 Bankruptcy?
Chapter 7 bankruptcies are probably what most people think of when they hear the term “bankrupt.” The chapter number simply refers to the section of the bankruptcy code relevant to the filing.
In chapter 7, all of the company’s assets are liquidated and the business will cease to exist. Upon liquidation, there are strict rules regarding the “order of precedence” that determines who gets paid first; as follows:
- Any Unpaid Taxes
- Secured Debts
- Unsecured Debits
- Bond Holders
- Preferred Stock Holders
- Common Stock Holders
As you can see, stockholders are at the very bottom of that list. The likelihood of equity owners getting anything in a chapter 7 bankruptcies is extremely low.
However, if a company did actually have cash left over after paying everyone else off, the remaining cash would be distributed in an equal amount per share. Therefore, if you have bankruptcy stock you might see some money.
2. What Happens to Stock in a Chapter 11 Bankruptcy?
Most of the time when a company files for bankruptcy, it’s a chapter 11. In chapter 11, the court protects the company until a detailed plan is submitted.
This outlines how the company will financially recover. The court has the authority to accept this plan; even without the consent of the creditors. However, creditors do have a voice in this process.
Chapter 11 bankruptcy usually will have a temporary trading freeze on the shares and is likely to be delisted. If the stock continues to trade on the OTC markets, a “Q” may be added to the ticker symbol to designate it as a company in bankruptcy.
There are a lot of potential outcomes for stockholders in chapter 11. But the most common is for the existing shares to be wiped out.
One of the common ways creditors will be compensated in chapter 11 bankruptcies is to be issued new equity shares; which probably means the existing shares will be canceled.
Each deal is different; the “devil is in the details,” as is often the case in stock market investing.
How to Avoid Companies in Danger of Filing Bankruptcy
- So hopefully I’ve convinced you that you generally want to avoid a company that is near or already in bankruptcy. But how can you avoid these companies to begin with? The answer is careful analysis of the company’s balance sheet. The balance sheet is one of three financial statements that companies must provide to investors every quarter when they announce their earnings results. It shows what a company owns, and how it is financed.
It’s called a “balance” sheet because the assets side (what's owned) must equal the sum of the liabilities plus owner’s equity side.
Liabilities is another term for debt. This is money that the company owes to creditors. Owner’s equity includes money that is paid into the company by investors as well as “retained earnings,”. Which are profits that the company keeps instead of returning to shareholders.
We've found that StockRover does a fantastic job of issing warnings and uncovering the fundamental details investors need to know. Take a look at $HTZ, which recently filed.
There are two simple ratios to look at that can quickly tell you if a company is on solid financial footing, or not.
1. The “Quick Ratio”
The quick ratio for bankruptcy stock, often called the “acid test” ratio, shows whether the company has enough cash on hand to pay their immediate obligations.
On the assets side of the balance sheet, you will find a line about halfway down called “Current Assets.” These are things like cash, short term investments, and accounts receivable (money that is owed to the company), less inventory (you can’t pay your bills with inventory).
In the liabilities section, you find “Current Liabilities,” which are debts that must be paid within the next twelve months. The quick ratio is calculated as Current Assets – Inventory/Current Liabilities. If this number is less than one, that's a red flag.
2. Debt to Equity Ratio
This one is a simpler calculation. But there isn’t such a hard line of what is good or bad. You really need to compare to other companies in the same industry to see if your company is better or worse than their peers; as different types of companies use debt differently.
The calculation is simply Total Liabilities/Shareholders’ Equity. In general, I like to look for companies around 1 or a little less. But again, some great companies use more debt to finance their businesses.
So you must understand the sector and bankruptcy stock you’re looking at to get a real clear picture of what the Debt to Equity ratio is telling you.
Bankruptcy Stock Conclusion
Debt isn’t always a bad thing. Using debt helps companies grow faster and make investments that they wouldn’t be able to make without it. As a result, bankruptcy stock can be good.
Also, interest reduces tax liabilities, so there is a fiscal benefit to using debt to fund a company. However, bad times will come in business.
Sometimes they come on out of nowhere for reasons completely out of a company’s control, as they have this year. In those down times, a strong balance sheet is often the difference between who survives, and who files bankruptcy.