Red Flags Signaling Bankruptcy Risk

When a company files for bankruptcy protection, many of its stockholders are taken by surprise and often lose most or all of their investment. You can save yourself a lot of heartache and dollars by learning to spot warning signs among your holdings.

A company goes bankrupt when it runs out of the cash it needs to operate. To assess a company’s bankruptcy risk, start with its debt load. Borrowed money can be helpful to a company, boosting returns in good times. But it can also amplify risk in bad times. A debt-laden company suddenly facing declining sales can cut its dividend — but it still has to make its interest payments, and eventually its principal repayment. Worse still, when the economy goes south, access to additional financing can be costly — or not available at all.

The amount of debt a company can handle is influenced by its industry. A utility company with predictable cash flows, for example, can manage debt better than retailers or manufacturers whose cash flows can fluctuate widely. (It can be helpful to compare a company’s debt level with those of its competitors.)

Industry aside, compare a company’s debt load to its cash — what it currently has on its balance sheet, and what it can generate. Ideally, it will be able to pay any debt due in the next year (often referred to as “short-term debt”) with cash on hand and make its interest payments many times over with its free cash flow. (You can find figures for assets, cash flow, debt and more at sites such as morningstar.com and

finance.yahoo.com, which offer data from companies’ financial statements.)

Look for other warning signs, too. Is its pension plan underfunded? Is its industry vulnerable to rapid obsolescence? Is it under investigation for any irregularities? Is the company buying back shares at inflated prices with money it should be using in better ways? Is it paying dividends when it can’t afford to?

Stay away from companies that appear to be candidates for bankruptcy court.