Bankruptcy risk is the possibility that a debtor will not be able to meet its debt obligations. Lenders and investors assess this risk when considering loan applications and business ventures. Factors such as debt burden, income, and money management skills are considered, along with bond ratings.
Also known as insolvency risk or default risk, bankruptcy risk is the possibility that a debtor will not be able to meet its debt obligations. Lenders assess this type of risk as part of the process of considering a loan application, line of credit, or any other type of financial assistance that involves repayment. Lenders also use a similar approach when evaluating business loan applications, taking into account all factors that relate to the business’s ability to repay that loan within the terms and conditions outlined in the loan agreement.
Along with borrowing and extending lines of credit, investors will also closely consider the risk of bankruptcy when considering investing in a business venture. For example, an angel investor considering backing a new business venture will take a close look at how the business is structured. He or she will also consider the background and experience of the owners, and the potential for success the business demonstrates, based on the goods or services that will be offered to consumers. If the angel investor determines that there is a strong market for those products, that the company has a well-planned and realistic business model, and that the owners have the experience and background necessary for success, he or she is likely to consider the level acceptable risk and choose to invest in the company.
Many of the same criteria that are used to determine a credit score also go into calculating bankruptcy risk. The relationship between debt burden and 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 those obligations on time without making late payments, are likely to be considered less risky. Demonstration of strong money management skills and a reputation for meeting all contractual obligations is also a strong indication that the debtor’s potential to file a Chapter 11 or Chapter 7 bankruptcy action is remote, assuming there is no Significant change in the circumstances of the debtor. .
Another useful tool for assessing bankruptcy risk associated with an established business is to consider bond ratings prepared by agencies such as Standard & Poor’s or Moody’s. These ratings are based on a careful examination of a company’s overall financial health and are especially helpful to investors. While helpful, it’s important to realize that strictly relying 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 whether a loan applicant is a low risk of bankruptcy.
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