Simple Insolvency Detection for Publicly-Traded Firms
Business Lawyer (Summer 2019)
25 Pages Posted: 16 Feb 2019 Last revised: 29 Apr 2019
Date Written: February 12, 2019
This article proposes a simple balance-sheet solvency test for publicly-traded firms that addresses current limitations of financial-market-based solvency tests. I derive a solvency test from an elementary algebraic relation among the inputs to the balance-sheet solvency calculation for a publicly-traded firm. The solvency test requires only the assumption that the market value of assets equals the sum of the market value of the firm’s debt plus the market value of the firm’s equity. The solvency test is a generated upper bound on the total amount of debt the firm can have and still be solvent, or, alternatively, the minimum amount of stock-market capitalization the firm must have if it is solvent at current debt prices. The virtue of the method — apart from its ease of implementation — is that it makes possible the detection of balance-sheet insolvent firms notwithstanding the possibility that not all of the firm’s liabilities — including hard-to-quantify contingent liabilities — can be identified. As a result, the method allows for the detection of many balance-sheet insolvent firms that otherwise might escape detection. The method proposed here may help identify insolvent firms that should be retaining assets and not paying them out to shareholders as dividends or repurchases, help identify stocks that should be treated by brokers and investment advisers as out-of-the-money call options that may be unsuitable investments or not in the best interest of advised investors, and help identify publicly-traded firms that are candidates for going-concern qualifications by auditors.
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