Bankruptcy Risk

Finance a la shmoop what is the going concern rule? I'm concerned that we're

still going are we dead yet can we still pay our bills any major [Zombie man discussing going concern rule]

contracts we're losing that will kill us any regulations coming that will also

kill us so we ask again are we dead yet? okay not quite a fair comparison there

when companies have to ask the question as to whether or not they are a going

concern well something is very rotten in Denmark like Google's not asking those

questions a going concern is one which is going living surviving even thriving [Pink rabbit playing drums]

and if they're not well then a whole lot of bad things start to happen so let's

say a given company has debt and one of the basic covenants is that their debt

has to have a debt to asset ratio of no more than 3x but then they invested in a

Chinese gambling company five years earlier which has done amazingly well [Chinese slot machine appears]

and that asset balloon and ballooned in value upwards the good way and the

company borrowed money against it as collateral

using the valuation of its last private round of funding to peg the value of

that asset okay debt to asset ratio remember got to be three but of course

as things always do in shmoop finance videos the Chinese gaming company was

hacked then it fell on hard times and it was regulated and eventually became an

impaired asset and that asset was no longer a going concern and that's a big

fat hairy problem for the company that was using that stock in that company as

an asset or collateral against which to cover its bond covenants when that

Chinese gaming asset became an impaired asset going in value from 50 million to [Chinese gaming company stock value graph appears]

like two million. The hundred fifty million dollars in debt covenants were

violated as the total assets owned by gambool went from seventy million dollars

down to just 22 million so what happens now?

well the bonds are by indenture immediately callable by the lenders and [Bond stamped callable]

it's unclear as to whether the company can quickly raise enough cash to cover

that debt that they owe... like they owe 150 million

bucks and the value of this thing's 22 so they quickly need to have 28 million

in cash or some asset that can be pledged against it so it doesn't violate

that 3 to 1 covenant got it? so it's as if the financial disease that hit the

Chinese gaming company has now leaked and infected the one that had invested

in it as now with that 28 million in change urgently needed the investing

companies own solvency is called into question yeah that's how we get to the

going concern rule which just focuses on the notion of whether a company is going

along just fine generally and that huge cataclysmic things like debt write downs

and bankruptcy aren't in the immediate offing at its essence going concern [Pink rabbit playing concern drum]

means that a company can continue to go or operate they can pay their bills good

economy or bad one contract or loss they're generally immune to minor

regulatory changes and any kind of debt they have or other production

obligations the timeframe for determining whether or not there is [Timeframe for companies cause for concern appears]

cause for concern that is going is usually a year from when the financial

statements are released that is if a company has had five hundred million

dollars in earnings before interest paid and then they pay four hundred million

dollars in interest payments well, they have only a hundred million dollars

of spread there but if suddenly their earnings drop another 20 percent well [Company earnings drop]

then their existence is likely called into question because basically all of

their pre-tax profits is going to pay down debt if revenues drop even another

little tiny skosh well then they're bankrupt and they're no longer a going

concern and well then investors would be concerned that they can no longer yo

know, go [TV advert for prunes appears]