MENU

What Happens if We Invest in a Company that Goes Bankrupt?

We’ve previously looked at how we should value a company that’s not making any profits. However, it’s worth noting that stock exchange operator Singapore Exchange (SGX: S68) has a practice of placing companies with three consecutive years of losses under a watch-list.

Some companies that are currently under the watch list include Aussino Group (SGX: A15), China Powerplus (SGX: Z02), FDS Networks Group (SGX: F07), and Grand Banks Yachts (SGX: G50).

For those who’re invested in companies that are part of the watch list, you have to be aware that there is a risk that the company may face bankruptcy in the future.

Bankruptcy

A company faces bankruptcy when it does not have enough cash flow to meet its normal operating expenses, which are most commonly the interest expenses on their debts. If we assume the company is not delisted, it will most likely have two paths to choose from; 1) restructuring or 2) liquidation.

1) Restructuring

In a restructuring, a company will need to renegotiate its borrowing terms with its creditors, which are either banks or bond holders.

During the renegotiation process, owners of the company’s common shares (a.k.a. common shareholders) normally have no say in the outcome. In some cases, the company may need to issue a large number of new shares to recapitalize the company.

This creates a huge dilution-risk for existing owners of the company’s common shares. For example, if one shareholder owned 10million shares in a company with 100million shares outstanding, he or she will be a 10%-owner of the company. However, if the company needs to issue 100million new shares to recapitalize itself, this increases the total share count to 200million. In such an instance, an owner who previously owned 10% of the company would wind up owning only 5% of the company instead.

2) Liquidation

A liquidation process may be considered one of the worst possible outcomes for an investor who owns common shares of a company.

It happens when a company has no other way to keep its daily operations going; as a result, it will have to sell off its assets to pay its creditors.

In a liquidation process, the owners of common shares will most likely end up with nothing; that’s because common shareholders are the last to lay claim to any of the resulting proceeds.

The situation is made worse by how most companies undergoing a liquidation end up having to sell their assets at “fire sale” prices, which come about due to the fact that a company is forced to sell but buyers aren’t forced to buy.

After all the assets are converted to cash, the company will need to pay any outstanding taxes. Creditors and employees are next in line.  And, we can’t forget the lawyers and consultants who are entitled to a share of the sale proceeds as well.

All told, by the time the liquidation is done – a process that can take years to complete -there is normally nothing left for common shareholders.

Foolish Bottom Line

Bill Gates, the co-founder of American software giant Microsoft, once famously said that he always ensured Microsoft had enough cash reserves to sustain its operations for an entire year even if it had no revenue coming in.

Companies with weak balance sheets and high debt loads face huge risks when they have a few lean years. As investors, it is best to keep that in mind when evaluating a company.

Click here now for your FREE subscription to Take Stock Singapore, The Motley Fool's free investing newsletter. Written by David Kuo, Take Stock Singapore tells you exactly what's happening in today's markets, and shows how you can GROW your wealth in the years ahead.  

The Motley Fool's purpose is to help the world invest, better. Like us on Facebook  to keep up-to-date with our latest news and articles.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.