Bankruptcy is a major risk that can sometimes blindside investors. For example, investors who were hoping to buy distressed coal stocks on the cheap back in 2012 were in for a rude awakening when several companies went belly-up with little to no warning. The problem is, there's rarely a clear-cut warning signal ahead of a bankruptcy filing, and many companies actually try to reassure their shareholder base that a turnaround is forthcoming right up until the bitter end.
Armed with this insight, our Foolish contributors offer five signs that shareholders should be on the lookout for when investing in companies with weak balance sheets or that are operating in industries with a poor outlook in the near term.
Tyler Crowe: This is more of an issue for companies in commodities and other cyclical businesses, but one thing that can signal that a rough patch is coming is when the company has to renegotiate its debt covenants. Aside from the typical things like interest payments and maturity dates, certain types of debt come with covenants. These typically require a company to maintain certain metrics, like staying below a set ratio of total debt outstanding to EBITDA, for example.
In the commodity world, profitability levels can evaporate very quickly and put companies at risk of breaking the covenants of their debt. When this happens, there are a whole lot of possible outcomes, such as severe restrictions on how much money can use in capital spending, or even worse, forced asset sales or other liquidation events. These sorts of things may help the bankers get their money back, but they can also be huge blows to the long-term viability of the company.
In the oil world recently, bankers and creditors have been pretty lenient with renegotiating debt that's in breach of its covenants. That doesn't mean, though, that this is the reception all companies in breach of debt covenants can expect. It may not be the sure-fire signal that a company is in its death throes, but it's enough of a warning that an investor should really take a deep look at the company.
Steve Symington: It's not always clear when companies are about to declare bankruptcy, but some of the surest signs of impending trouble are painfully unfavorable terms from lenders.
Take RadioShack, for example, which filed for bankruptcy just over a year ago after 94 years in business. The writing was on the wall; I even wrote a full eight months earlier that RadioShack could be bankrupt in 2015, partly because its prior terms for obtaining $835 million in much-needed financing in late 2013 dictated it could close no more than 200 stores per year. Unfortunately, RadioShack management subsequently stated it needed to close as many as 1,100 "lower-performing" stores in an effort to stem the company's widening losses -- a number that would take more than five years to achieve per the terms of that earlier debt. Worse yet, when RadioShack went back to its lenders for permission to implement the more aggressive store closure plan, negotiations failed, RadioShack stated, because "The terms on which the lenders are currently willing to provide this consent [were] not acceptable to the Company."
Finally, though shares of RadioShack briefly skyrocketed in the month before its bankruptcy on news of an unsolicited $500 million loan offer from Salus Capital -- which RadioShack itself pointed out was one of the key lenders blocking its requests to accelerate store closures -- that money was actually a debtor-in-possession loan, which is typically used to fund operations in bankruptcy and meant to increase a lender's influence should the company initiate a Chapter 11 filing. In the end, though investors who bet earlier on a successful turnaround had already lost much, those who heeded the red flags that arose from RadioShack's unfavorable lender terms in the first place were saved from even more severe financial losses.
Sean Williams: There is no definitive sign investors can look at to determine whether or not a company is about to go bankrupt, but one of the more likely signs that a company is in trouble can be found in its debt. Specifically, discussion of a debt restructuring, or of a potential missed interest payment, could be a major warning flag.
Debt itself isn't necessarily bad for businesses if it's used properly. Debt can be used for expansion, hiring, the development of new products and services, and even acquisitions. However, if debt becomes excessive relative to cash flow and cash on hand, there could be a problem. Some businesses have indeed used the current low-rate environment to restructure their debt despite being financially sound. However, more often than not, a publicly traded company that's under heavy selling pressure from Wall Street and is discussing a possible debt restructuring is doing so because it may not be able to cover its interest and principal obligations down the road.
Take solar company SunEdison (NASDAQOTH:SUNEQ) as a good example. In January, its stock valuation nosedived after it announced a complex debt restructuring, which also included a dilutive common stock offering to improve its liquidity position by $555 million. Additionally, SunEdison is in the process of acquiring residential solar panel installer Vivint Solar (NYSE:VSLR) in a cash and stock deal. This deal doesn't exactly speak to SunEdison's core business strengths.
While bankruptcy talk isn't on the table at the moment, SunEdison's precarious debt position and ongoing losses could make this company a bankruptcy concern if things don't change soon.
Andres Cardenal: Companies with consistently declining sales can be particularly risky investments, especially when the decline in revenue is combined with persistent losses and high debt levels. Unfortunately for investors in Sears (NASDAQ:SHLD), the company fits that description quite well.
Sears announced dismal performance for the quarter ended on January 30. Total revenue declined by 9.9% year over year, from $8.1 billion to $7.3 billion. Comparable-store sales fell 7.1% during the quarter because of a 7.2% decline at Kmart and a 6.9% decrease at Sears Domestic. The trend has been in place for quite some time now: Same-store sales have declined in every year since 2005, and the company has produced net losses over the last five consecutive years.
Sears has recently secured a new $750 million credit facility, and the loan is priced at LIBOR plus 750 basis points and sold at a 3% discount. Sears will receive $720 million in net proceeds from the facility, and the company is planning to use that money to to reduce borrowings under its asset-based revolving credit facility. The loan will provide some breathing room for Sears, but the company is paying a high interest cost for this debt, which will put additional pressure on earnings over the middle term.
Unless Sears can bring customers back to the stores and reverse the declining sales trend, everything suggests that bankruptcy risk will continue increasing in the middle term.
George Budwell: Echoing my Foolish colleagues, I don't think there's a single definitive sign that a company is about to go bankrupt, but sudden, unexpected, changes in leadership can be certainly be a major warning that the ship is sinking. In 2014, for example, now-defunct cancer immunotherapy company Dendreon Corp. saw its CEO John Johnson resign seemingly out of the blue, citing "personal reasons" for his departure. Making matters worse, Johnson's sudden resignation coincided with a looming debt payment that the drugmaker appeared unable to make at the time.
As the story goes, Dendreon would indeed fold only a few short months after Johnson tendered his resignation, paving the way for the company's prostate cancer treatment Provenge to be acquired by Valeant Pharmaceuticals (NYSE:BHC) at a bankruptcy auction in early 2015.
The sad part of the story, though, is that many faithful shareholders held out hope that Johnson's departure would spell a reversal of fortunes for the struggling drugmaker, resulting in catastrophic losses for those who failed to grasp the seriousness of Dendreon's cash flow problems. In fact, some shareholders attempted to block the sale of Dendreon to Valeant, given that the net sales price wouldn't even cover the company's outstanding debts, leaving shareholders holding the bag, so to speak.
So, perhaps the key takeaway from Dendreon's collapse is that a managerial shake-up during on ongoing financial crisis might be a strong indication that it's time to hit the exits -- even if the stock has lost a substantial amount of its valuation. After all, something is better than nothing.
Andres Cardenal has no position in any stocks mentioned. George Budwell has no position in any stocks mentioned. Sean Williams has no position in any stocks mentioned. Steve Symington has no position in any stocks mentioned. Tyler Crowe has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Valeant Pharmaceuticals. Try any of our Foolish newsletter services free for 30 days.