BANKRUPTCY

Definition

Bankruptcy is a legal process through which individuals or businesses that cannot repay their outstanding debts seek relief from some or all of their obligations. In bankruptcy proceedings, a court assesses the debtor’s financial situation and determines how creditors will be repaid—either through asset liquidation, debt restructuring, or repayment plans.

It serves both as protection for debtors and a legal mechanism for creditors to recover owed funds.

Origins

• From the Italian phrase banca rotta (“broken bench”), referring to medieval moneylenders whose trading benches were physically broken to signify insolvency.

• The concept evolved into formalized insolvency laws in England in the 16th century and spread globally as commercial economies developed.

Usage

• Corporate bankruptcy – Companies reorganizing under legal protection.

• Personal bankruptcy – Individuals seeking debt relief.

• Sovereign bankruptcy – Nations restructuring debt obligations (technically “default” rather than bankruptcy).

• Bankruptcy protection – Allows entities to continue operations while restructuring.

How Bankruptcy Works

1. Filing – Debtor (or creditors in involuntary cases) petitions for bankruptcy.

2. Automatic Stay – Court halts most collection actions.

3. Asset Review – Court-appointed trustee examines assets, liabilities, and claims.

4. Debt Resolution – May involve liquidation or a reorganization plan.

5. Discharge – Eligible debts are forgiven; case is closed.

Types of Bankruptcy (U.S. Context)

Chapter 7 – Liquidation 

• Assets sold to repay creditors; remaining debts discharged.
• Common for individuals and small businesses with no viable restructuring path.

Chapter 11 – Reorganization

• Used by corporations to restructure debts and continue operations.
• Creditors may receive equity in the reorganized company.

Chapter 13 – Wage Earner’s Plan

• Individuals create a 3–5 year repayment plan while keeping assets.

Note: Other countries have similar structures under different names.

Key Takeaway

• Bankruptcy ≠ total loss – Some assets or operations may survive.

• Can be voluntary or involuntary.

• Impacts creditworthiness for years.

• Affects shareholders, employees, creditors, and suppliers.

Context in Financial Modeling

In financial modeling, bankruptcy is the point where a business can no longer meet its debt obligations, leading to legal insolvency proceedings or restructuring.

It’s usually modeled as a worst-case scenario and can appear in contexts like:

• Forecasting liquidity shortfalls where projected cash flows turn negative and no funding source is available.
• Testing loan covenants to see if financial ratios (e.g., debt service coverage ratio, current ratio) fall below lender requirements.
• Restructuring or recovery analysis to estimate how much creditors and shareholders would receive if the company fails.
• Scenario analysis to measure how economic shocks, revenue drops, or cost increases could push the company into insolvency.

Nuances & Complexities

• Priority rules – Secured creditors are paid before unsecured creditors and shareholders.

• International differences – Bankruptcy law varies by jurisdiction.

• Strategic bankruptcy – Some companies file to restructure debt on favorable terms.

• Fraud risk – Concealing assets during bankruptcy is illegal.

Mathematical Formulas

 Bankruptcy probability can be modeled using credit risk metrics like:

Altman Z-Score:

$$Z = 1.2X_1 + 1.4X_2 + 3.3X_3 + 0.6X_4 + 1.0X_5$$

Where:

• $X_1$ X 1​  = Working Capital / Total Assets
• $X_2$ X 2​  = Retained Earnings / Total Assets
• $X_3$ X 3​  = EBIT / Total Assets
• $X_4$ X 4​  = Market Value of Equity / Total Liabilities
• $X_5$ X 5​  = Sales / Total Assets

Lower Z-scores indicate higher bankruptcy risk.

Related Terms

• Insolvency

• Liquidation

• Debt Restructuring

• Default

• Creditor Priority

• Altman Z-Score

Real-World Applications

 Lehman Brothers (2008)

Largest U.S. bankruptcy filing in history, with $600B in assets, triggering global financial turmoil.

General Motors (2009)

Filed for Chapter 11, restructured with government support, and returned to profitability.

Personal Bankruptcy

An individual with $150,000 in credit card and medical debt files Chapter 7, liquidates non-exempt assets, and receives a discharge.

• Annual return = 10%

• Risk-free rate = 2%

• Std. deviation = 12%

• Sharpe Ratio = $(0.10 - 0.02) / 0.12 \approx 0.67$ → Below average.

   

References & Sources

• U.S. Courts – Bankruptcy Basics

• World Bank – Insolvency and Creditor Rights Systems

• Wiley Online Library – Altman, E. (1968): Financial Ratios, Discriminant Analysis, and the Prediction of Corporate Bankruptcy