Bankruptcy: Meaning, Cause and Consequence

Bankruptcy is the legal proceeding involving a person or business that is unable to repay outstanding debts. It offers an individual or business a chance to start fresh by forgiving debts that simply cannot be paid while offering creditors a chance to obtain some measure of repayment based on the individual’s or business’s assets available for liquidation. Bankruptcy is generally understood to have two purposes.

  • The first purpose is to give individuals and companies the chance to get a fresh start when faced with financial problems.
  • The second purpose is to give creditors an equal chance to recover what is owed to them by the debtor.

Bankruptcy has also been described as a tool that “greases the wheels of a capitalist economy, offering a safety valve that somewhat tempers its harshness for those who do not fare well in free-market competition. It also encourages risk-taking and expansion”

Causes for Bankruptcy

  • Market Conditions: Poor conditions in the overall economy and the specific market in which a business operates are common causes for bankruptcy. The economy tends to follow a boom and a bust cycle of rapid expansion followed by lulls or recessions. During bust periods, consumer confidence and spending tend to decline, which can lead to low revenue. Companies involved in specific niche markets can also be susceptible to shifts in consumer preferences. Competition from larger companies can cut into the revenue of small companies and lead to bankruptcy.

For example, a small business owner that owns a music store might be forced to close shop due to digital availability. Similarly,

  • Financing: Financing is one of the primary challenges that small businesses face. Many business owners take out loans to help finance their operations. If a business struggles, his lender may not be willing to grant additional funding, which could lead to bankruptcy. Even if an owner can secure more financing to keep his company afloat in the short-term, high debt makes it more difficult for a company to be profitable because it has to pay interest on the debt.
  • Poor Decision Making: Lack of planning and level-heading thinking can lead to hasty decisions and business failure. For example, a business owner might spend time and money developing a product that she believes in without surveying customers and studying production costs to gauge whether the product could be profitable. Even if the product is useful, it might not be financially viable from a business standpoint.

Lack of education and experience in finance and management can increase the likelihood of poor decisions, but no company is immune to making mistakes.

  • Other Causes: Bankruptcy can result from a host of other underlying problems that inhibit profitability. Some other factors that can contribute to bankruptcy include poor business location, loss of key employees, lawsuits raised by competitors and personal issues like illness or divorce. Unforeseen disasters and criminal activity like floods, storms, fires, theft and fraud can also cause hardships that lead to bankruptcy.

Consequences of Bankruptcy

Perhaps the most well-known consequence of bankruptcy is the loss of property. Any bankruptcy proceedings can require you to give up possessions for sale in order to repay creditors. Under certain circumstances, bankruptcy can mean losing real estate, vehicles, jewelry, antique furnishings and other types of possessions.

Bankruptcy can also affect others financially i.e. investors, workers promoters etc. For example, if your parents co-signed an auto loan for you, they could still be held responsible for at least some of that debt if you file for bankruptcy.

Finally, bankruptcy damages the credit position. Bankruptcies are considered negative information on your credit report, and can affect how future lenders view you. Bankruptcy situation in one’s profile will discourage creditors to extend credit limit. Also, in such situation, when credit is allowed, it is allowed at higher interest rates or less favorable terms.

The bankruptcy phase and the negative information regarding bankruptcy will affect the business and person in long-term. Such negative information rumored during bankruptcy may affect the credit profile of business or person. The impact of such activities is seen in future while looking for credit.

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