Bankruptcy Red Flags

A company goes bankrupt when it runs out of cash to pay its obligations (such as rent, employees, vendors and debt). The first thing to look at when assessing bankruptcy risk is a company's debt position.

While debt can boost returns in good times, it can 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 bad, access to additional financing gets expensive or simply unavailable.

How much debt is too much? Acceptable levels vary by industry. High debt can be manageable for a utility with predictable cash flows, but it's worrisome in tech firms, retailers or restaurant chains — all of whose cash flows can vary widely. (It can be useful to compare a firm's debt level with its competitors.)

Regardless of industry, view a company's debt position in the context of its cash — what it currently has on its balance sheet, and what it can generate. Ideally, it can pay any debt due in the next year with cash on hand and make its interest payments many times over with its free cash flow. (That's cash flow from operations, minus its capital expenditures.)

Cash and debt aside, look for other red flags. Does the company have an underfunded pension plan? Is it invested in risky derivatives? Does it perform in an industry that is susceptible to rapid obsolescence?

And then there's plain old corporate stupidity: Is the company buying back shares with money it should be saving to ride out the recession? Is it paying dividends, when it's clear that it needs that cash to fight for its life? Missteps like these can push an otherwise solvent company right into the arms of bankruptcy court.

It's smart to stay away from companies that are likely to end up filing for bankruptcy. By definition, they aren't stocks you can hold for the long term, and their underlying businesses have clearly experienced some missteps.