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Why Do Companies Go Bankrupt?

Many of us think that a company can go bankrupt simply because it took on too much debt or it has a bad business model. However, many high-debt companies and bad businesses still continue to survive as well. So, why do some companies faced the failure of bankruptcy while some do not?

The key is liquidity

A company would have bills to pay and revenue to earn. A company will only fail if it is unable to pay back its bills and its suppliers, or its bank decides to take legal action against the company’s failure to pay.

In short, a company would only fail if it does not have the money to pay back its short-term bills and debt. The key here is the lack of liquidity could bring a company to bankruptcy.

Liquidity is not the same as having high debt or having a bad business model. In theory, a company can take on an infinite amount of debt to fund its business. As long as the banks are willing to continue lending it money, even to just repay its old debts, the company can still continue to survive.

If a bank decides to stop giving out more loans to a company which is unable to repay its interests, then the company might face the risk of bankruptcy.

Loans and equity

The key here is for the company to have enough cash to meets its dues. When a company is unable to obtain cash from borrowing more from the bank, it can choose to raise more equity. This can be done through a rights issue, private placement or even a new initial public offering in some other stock exchanges. All these might provide the company with more funds to meet its short-term dues.

However, just by borrowing more and more money or raising more money through equity does not seem like a sustainable strategy. That is why many of these types of companies would face financial difficulties sooner or later.

At the end of the day, a well-run company that is able to generate good free cash flow is best protected against the risk of bankruptcy.

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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.