Capital Structure and Bankruptcy
Corporate capital take two forms: bonds and stocks. Bonds pay a fixed amount to their holder after a certain period. So, if you buy a one year bond for $100 which yields 5%, you will get a check from the corporation for $105 one year later. If at any point a corporation does not have the money to pay a bond, it faces bankruptcy. Corporations cannot simply decide to pay less than the face value of the bond. Bondholders do not get a say in how the company is run. Stockholders, on the other hand, get to pick the CEO and influence other operations. Stocks do not pay a fixed amount. Their payments, which are called dividends, fluctuate based on how well the corporation is doing and how much extra money is available. In the long run, dividends are not optional, since no one would buy a stock unless they thought that there would be some future dividends. But in the short run, dividends can be suspended if the corporation faces rough times. Stocks are the flexible part of the balance sheet and bonds are rigid.
Leverage is the ratio of bonds to stocks. The more bonds a corporation issues in relation to the value of its stocks, the more leveraged it is. Financial firms are typically leveraged 30-1 or more, which means that if their income drops even a small amount, they may not be able to pay the bonds. Firms may accumulate assets in order to weather rough times. The graphs show a firm without asset reserves.
For example, the graph below shows a firm which is leveraged 3 to 1. The red represents the bond payments and the blue represents the stock dividend payments. The firm can weather a poor year and still be solvent.
If a firm had some assets it could sell, it would be able to draw that down to pay off the debt and survive until year 4. If a firm’s total assets are less than their total liabilities, the firm is “balance sheet insolvent”, which is subjective and touchy feely. Lenders would be concerned by balance sheet insolvency, because if asset prices remained the same, the firm would not be able to pay them back in the long run. Cash flow involvency, which is being unable to pay creditors, is cut and dry; you can either make the bond payments or you can’t. Cash flow insolvency is sometimes called illiquidity when talking about the banking sector, which refers to a bank being unable to borrow from some investors to pay off others. In the financial sector, insolvency is often avoided by the government giving the insolvent firm as much money as it needs to keep making bond payments. However, outside the financial sector, firms which cannot make bond payments go into bankruptcy.
When a firm goes bankrupt, there are two options: liquidation and reorganization. In a liquidation, all of the firms assets are sold and the proceeds are used to pay the bondholders. In a reorganization, the bondholders become the new owners and instead of getting a payment, they get stock in the new firm. Bankruptcy is the recycling of capitalism; it reallocates resources from unprofitable companies to profitable ones or allows firms to reorganize.