What happens when a firm goes Bankrupt and is liquidated?

Should a public business go bankrupt and stop all operations to go out of business, a trustee will be appointed to liquidate the company’s assets. The remaining funds will be used pay off creditors and reimburse investors as much the company can. Here is how funds are divided between investors following a bankruptcy situation:

  • Secured Creditors: These are the investors who took the lowest level of risk and are the first to be paid. Secured investors, for example usually have their credit backed by collateral such as a mortgage or company assets.
  • Unsecured Creditors: This might include bondholders/banks. These have the second claim to the assets of the firm as firms have a legal requirement to pay debtors before stockholders.
  • Stockholders: Stockholders have the last claim to the assets of the firm and will only be paid after both secured and unsecured creditors have been paid. In a bankruptcy situation stockholders will often receive nothing.

Should the business operate as a partnership/sole trader, the individuals are liable for the debt of the company and may have to declare personal bankruptcy.

Preventing a business from going bankrupt

Should a business be heading toward bankruptcy, the best thing to do is to implement measures that prevent insolvency. These include:

  • Restructure: This may include selling-off some parts of the business to raise funds. Non-essential capital projects may be abandoned/postponed for cost saving.
  • Refinance: This includes coming to an agreement with creditors which might enable business owners to delay payments or pay interest back over a longer period of time.
  • Recapitalize: Businesses may look to financial markets and sell more shares in order to raise capital. This has the effect of diluting ownership and is generally very badly received. It may be the only option for firms in severe distress.

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Motley Fool contributor Marcello Pinto has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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