Corporate Finance Explained | Why Companies Go Bankrupt

Okay. Think about this for a second. What do companies like Lehman Brothers, Toys R Us, WeWork, maybe even Kodak, what do they all have in common?

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Well, they were all huge names, obviously. Right. Exactly. They dominated the headlines, but not always for the best reasons, right? They all face these really dramatic financial collapses. Yeah. Deep, deep trouble. So today we’re going to do a deep dive into that whole world of corporate financial failure. We want to figure out, you know, what are the early warning signs? What really makes these companies stumble? And crucially, what can finance teams actually do before it’s way too late? That’s the goal. Our mission here is to pull out the most important nuggets of knowledge from all the research out there on corporate finance, insolvency. Basically give you a shortcut to understanding what cracks might be hiding under the surface of a company. That’s a great way to put it because, you know, while the reasons for each collapse were different, sometimes wildly different, like you said, complex finance stuff, retail shifts, even that whole co-working hype, the early signs, they were almost always there. You could see them in the numbers for sure, but also in the big strategic calls being made, or maybe more importantly, the ones not being made. Oh, okay.

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So yeah, this deep dive, it’s really about arming you with the kind of foresight you need to spot those signals yourself. Okay. Let’s unpack this then. Yeah. When we talk about a company failing, it’s usually not like, boom, one single event, right? It’s more complicated. So why do companies actually go bankrupt? You’re absolutely right. It’s almost never just one thing. Think of it more like a perfect storm, maybe. Financial failure, it’s usually this complex mix of different factors all hitting at once. Okay. The sources we looked at, they keep pointing to a few common culprits, things like really poor cashflow management sometimes that gets hidden by profits that look okay on paper, or excessively high leverage basically, just way too much debt compared to their ability to actually pay it back. Then you’ve got things like unrealistic growth plans, maybe expanding too fast. Trying to run before they can walk. Sort of, yeah. Outpacing the market or their own capacity. And a big one, just not being able to adapt when the market fundamentally changes or when new technology disrupts things. And what’s interesting is how these things feed off each other, like those unrealistic growth plans. They can directly lead to taking on way too much debt, that high leverage we talked about. I see. So it becomes a cycle. Exactly. A dangerous cycle. And then if the market shifts even slightly, things can spiral out of control really fast. Okay. So it’s rarely just one punch. It’s more like a combo. And we should probably clarify the terms here too, right? Because insolvency and bankruptcy, they aren’t quite the same thing. Absolutely. And that’s a really crucial distinction to make. Insolvency, that describes the state a company is in. It just means they can’t pay their debts when they’re due. It’s a cash crisis maybe, or their liabilities are just bigger than their assets. Got it. So that’s the situation. Right.

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Bankruptcy, on the other hand, that’s the formal legal process they go through to deal with that insolvency. And that process can lead down two main paths. Either liquidation, selling everything off to pay the creditors whatever they can get, or restructuring. That’s where they try to reorganize the debt, maybe change operations, basically try to survive and get healthy again. So one’s the problem, the other’s the potential solution, or at least the process. You got it. And the key takeaway here, most bankruptcies, they don’t just happen overnight, those red flags. They are almost always waving, sometimes for a long time, in the financial reports and in the big strategic decisions, well before any lawyers get involved. Okay. This is where it gets really practical, I think. For anyone trying to figure out if a company is healthy or not, what should you actually be looking for in the numbers? What are those flags? Right. Let’s shift from the why to the what to watch for.

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There are about five core things, indicators that everyone should really keep an eye on. First up, declining operating cash flow. Okay. Operating cash flow. Why is that so important? Well, a company might still be showing a profit, right? On the income statement. But if the actual cash coming in from its main business operations is consistently going down, that signals a really deep underlying weakness. Because profit can be massaged a bit with accounting, but cash is cash. Pretty much. Cash flow doesn’t line nearly as easily. So even if profits look okay, falling cash flow. Big red flag. Okay, that makes sense. What’s number two? Second is rising leverage ratios. You need to watch for steady increases in metrics like debt-to-equity or, maybe even more telling, debt-to-EBITDA. EBITDA, right. Remind us what that is again. Sure. It’s earnings before interest, taxes, depreciation, and amortization. Basically, it’s a rough measure of a company’s core operating profit before you factor in financing costs, taxes, and those non-cash expenses like depreciation. Gotcha. So, the debt-to-EBITDA going up is bad. Right. The research suggests that once you get beyond, say, a four X debt to EBITDA ratio, you’re getting into pretty risky territory. Four times. How should we think about that? Well, think about it personally. If your mortgage was four times your annual salary before taxes, you’d feel pretty stretched, right? Definitely. Not much wiggle room. Exactly. For a company, it means there’s very little cushion, any downturn, any unexpected cost, and paying back that debt becomes incredibly difficult. Okay, that puts it in perspective. Four times is a lot. What else? What’s number three? Third is negative working capital trends. This is a classic sign of a liquidity crunch. It means their short-term liabilities, the bills they have to pay soon, are regularly higher than their current assets like cash, where things they can quickly turn into cash. So not enough ready money to cover immediate bills like living paycheck to paycheck for a business. That’s a perfect analogy. It means they’re constantly scrambling. Fourth indicator, interest coverage, deterioration. Interest coverage. So how well they can cover the interest payments on their debt. Exactly. This looks at their earnings before interest in taxes EBIT and compares it to their interest expense. If that ratio starts shrinking, it means more and more of their operating earnings are just going to service the debt, leaving less for reinvestment, growth, or anything else. Which obviously increases the risk they might default. Absolutely.

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And then the fifth one, frequent refinancing or constantly rolling over short-term debt. So they’re not paying down debt, just shuffling it around. Pretty much. It’s a sign they’re depending on friendly markets or finding new lenders just to keep their head above water instead of generating the cash internally to handle their debts. It’s like borrowing from Peter to pay Paul, a strategy that almost never works long-term. That sounds exhausting and risky. Okay. So those are the five big ones. Are there more formal tools people used to? I think I’ve heard of Altman Z score.

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Yes, absolutely. Tools like the Altman Z score. They basically combined several of these financial ratios into a single score. And it’s surprisingly good at predicting the probability of bankruptcy. It gives you a kind of quick snapshot of risk. And then you also have financial covenants. These are specific conditions that lenders build right into loan agreements. Think of them like tripwires. Tripwires. How so? Well, if a company breaches a covenant, maybe their debt to EBITDA goes above that forex level we talked about, or their interest coverage drops too low. It can trigger an immediate default or specific actions. It lets lenders step in early, maybe force restructuring or demand repayment before everything completely collapses. They’re like an early warning system built right into the debt itself. Okay. That makes a lot of sense. So we have the theory, the red flags, the tools. What does this actually look like in the real world? Let’s connect it back to those companies we mentioned. Lehman Brothers, for example. That felt so sudden in 2008, like an earthquake, but you’re saying the signs were there. Oh, absolutely. For anyone watching the numbers closely, Lehman’s collapse wasn’t sudden at all. Their biggest issue, just unsustainable leverage. At its peak, it was over 30 to one. 30 to one. Wow. So for every dollar of their own money, they had borrowed over 30. Exactly. And that insane leverage was piled onto huge bets on those toxic mortgage-backed securities, assets that quickly turned worthless. So it wasn’t just the amount of debt, but the really poor quality of the assets backing it up. So where were the early warnings there? They were clear as day in their declining liquidity ratios, their ability to meet short term obligations was shrinking. And maybe even more critically in their soaring credit default swap spreads, CDS spreads. CDS spreads. Right. That’s like the market’s bet on whether they’ll default. Precisely. It’s like an insurance premium on their debt. When Lehman’s CDS spread started shooting through the roof, that was the market screaming that it had lost confidence. That was happening months before the final bankruptcy filing. Okay. So the market saw it coming.

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Now, what about a totally different kind of company like Toys R Us? That seems less about complex finance and more about, well, Amazon. That’s right. Toys R Us filed for Chapter 11 in 2017, and their story is really a cautionary tale about debt, specifically debt from a leveraged buyout in LBO. Ah, the LBO curse. It can be. They were loaded up with debt from a 2005 LBO and a key number for them. Their interest expense. It was costing them over $400 million a year. Wow. Just on interest. Just on interest. And that massive payment basically choked their ability to do anything else. They couldn’t reinvest in their stores. They couldn’t build a decent online presence to compete with Amazon and others. They were just treading water, trying to pay off the debt. So the debt prevented them from adapting. Exactly. And you saw it in their working capital cycle too. As they got weaker, suppliers got nervous and started demanding quicker payments, shortening their terms. That just squeezed their cash even more, creating this vicious cycle. It shows how a bad capital structure can kill even a beloved brand. Okay. And then there’s the more recent hype driven one, WeWork. That felt different again. WeWork is fascinating. Yeah. It really highlights how a great story and super-fast growth can sometimes hide pretty fundamental financial problems. They were gearing up for this huge IPO in 2019, but once they had to actually show their numbers publicly, The wheels came off. Pretty much. People started asking hard questions, and it wasn’t just that the valuation was maybe inflated. The real insight there is this fundamental mismatch in their business model. Mismatcho. They had short-term revenue, monthly memberships, but they had massive long-term liabilities, these really long leases on all their office spaces that created this huge hole in their balance sheet. Ah, so the money coming in didn’t match the money they were committed to pay out long-term. Exactly. And they were burning through cash like crazy, over $2 billion a year, with no clear way to actually become profitable. It just showed that even a cool disruptive idea needs a sustainable financial engine, not just investor hype and growth at all costs.

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Back to basics, even for the disruptors, what about a really classic example like Kodak? That seems like a failure to innovate, right? Kodak is the textbook case of strategic inertia, really. They filed for bankruptcy back in 2012, and it wasn’t because of some crazy LBO debt or a flawed business model like WeWork initially anyway. It was because they just failed to adapt to digital photography. Even though they invented the first digital camera, right? Yes, the irony. They invented it, but they couldn’t pivot away from their legacy film business. And the deeper insight here is that the finance teams, they probably saw the warning signs early on. They would have seen the falling margins, the declining revenues from film. But the company couldn’t change direction. Exactly. Leadership was stuck. They were too dependent on those shrinking film sales, and they just couldn’t or wouldn’t make the hard choices to truly embrace the digital future they helped create. It really shows how financial health and strategic agility are totally intertwined. Sometimes the numbers are just confirming a strategic failure that happened years before.

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Okay, so when companies do get into this kind of deep trouble financial distress, the spotlight really swings onto the finance team, doesn’t it? What’s their role when things start going south? It sounds incredibly stressful. It is. They are absolutely on the front lines. Their role shifts dramatically. They go from just reporting the numbers to becoming active, hands-on problem solvers. And different parts of the finance team have different critical jobs. Like who does what? Well, you’ve got FP&A, financial planning and analysis. Their job is suddenly to rebuild all the forecasts, but this time with brutally realistic assumptions. No more rosy projections. Right. You’ve got to face facts. Exactly. They have to stress test cash flow. What happens if sales drop another 20%? How long can we last? They help figure out which parts of the business are truly essential and need to be protected. Maybe which ones need to be cut. Okay, so they’re mapping out the survival scenarios. What about the actual cash? Who manages that? That falls squarely on the Treasury team. Their world becomes incredibly intense. They’re the ones talking to the banks, trying to renegotiate loan terms, maybe secure emergency bridge financing just to keep the lights on. High pressure. Absolutely. And they’re also managing relationships with suppliers, trying to stretch out payments, maybe reassure them just to keep critical supplies coming in and preserve every last drop of liquidity. They’re like the financial paramedics.

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And then at the top, CFO. Right. Finance leadership, the CFO, the VP of finance. They’re working overtime with the CEO, the board, lawyers, maybe restructuring advisors. They’re evaluating all the big, tough options. Can we turn this around operationally? Do we need to sell off parts of the business? Is a formal bankruptcy filing the best or only option left? Wow. It sounds like communication must be key through all of this. It’s the key. The absolute keyword is transparency. During a crisis, during any turnaround attempt, your credibility with everyone, lenders, suppliers, employees, investors is everything. If people stop trusting you, stop believing what you’re telling them, your options just evaporate. Honesty, even when the news is bad, is paramount. That makes total sense. Yeah. Okay.

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So, looking back at all these stories, these failures, what are the big lessons? What can you listening right now take away from this that applies to pretty much any company, any industry? Yeah, there are definitely some universal takeaways here. First, I’d say you absolutely have to track the metrics that really matter, not just the vanity metrics, but the core health indicators we talked about. Like cash flow and leverage? Exactly. And critically, you need the courage to raise the flag early, even when it’s uncomfortable, even if it goes against what everyone else wants to believe. Ignoring those early warnings, that’s a death sentence, corporately speaking. It’s like ignoring chest pains until you have a massive heart attack. Okay. Track the right stuff and speak up. What else? Second, cash is king, especially in a downturn. Companies get obsessed with profit, but profit on paper doesn’t pay the bills. Cash does. You need financial models that don’t just assume smooth sailing, but actually stress test your liquidity. What happens in the worst case scenario? Knowing how long your cash will really last is vital. So focus on cash, stress test everything. What about the internal stuff, how the companies run? Great point. Third lesson, governance and controls matter a lot. Having a strong independent finance function, particularly a CFO who reports to the CEO but is also truly accountable to the board, acts as a vital check and balance. It’s not just about catching fraud then. No, not at all. It’s about ensuring sound financial discipline permeates the whole company. It can prevent leadership from taking overly risky bets or chasing growth without considering the potential downsides. Good governance provides guardrails. Okay.

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And you mentioned strategic issues earlier, too. Right. And that leads to the fourth point. Don’t ignore the soft signs, things that might not show up immediately on a spreadsheet. Like what? Like high employee turnover, especially key people leaving, declining customer satisfaction or retention rates, suppliers getting nervous and changing terms, like we saw with Toys R ‘ Us, or even just a shift in how the market perceives the company. These soft signs often signal deeper problems that will eventually hit the financials. You need to look beyond just the numbers on the page. Absolutely. Ultimately, whether you’re in finance, strategy, operations, wherever, your job isn’t just about recording history, figuring out what already happened. It’s about looking ahead, anticipating what might happen, and helping the whole organization get ready for it. That’s a really powerful way to think about it. Finance, not just as scorekeepers, but as navigators, looking out for both the opportunities and, well, the icebergs, staying alert, staying analytical, and having the courage to speak up, seems absolutely critical if you want to avoid becoming the next cautionary tale. Exactly.

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And maybe here’s a final thought for everyone listening to Malover. In this world we live in now, with everything so interconnected, changing so fast, think about your organization. How could you identify and maybe start mitigating an emerging non-financial risk? Non-financial, like what? Like, say, a big shift in environmental regulations coming down the pike, or a major social movement that could impact your brand or your customers. Maybe a sudden technology disruption that isn’t obvious yet. How do you spot that kind of risk before it turns into a financial crisis? Because sometimes the earliest warnings aren’t on the balance sheet at all. That’s a really interesting challenge to think about. Definitely something to chew on.

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Well, until next time, keep learning, keep forecasting, and keep building those resilient finance teams wherever you are.