Readers Question: How Much Loss Can A firm Make before going Bankrupt?
Firms who make a loss, will not necessarily close down. There are various ways that firms can keep going
- Borrowing from Bank. Bank will offer loans if it considers the firm is likely to make a profit in the future.
- Selling shares. A firm can also raise funds by a share issue. Selling shares to raise funds. e.g. Eurotunnel required a large share issue to fund the investment for digging a tunnel.
- Running down reserves from profitable years.
What Determines How Much a Firm can lose Before Going Bankrupt
Size of Assets. A bank will have more faith in a firm with substantial assets. In a worse case scenario the assets can be sold and bank gain some of its losses back.
Future Prospects. Is the loss a one off or permanent decline in business. e.g. if BP faced a huge bill for the Arizona oil spill, this is likely to be a one off charge and this shouldn’t effect its future profitability. A firm in a declining industry like coal or record shop may not have this future optimism. A firm like General Motors is more uncertain. The car industry has a future, but, do GM have the management to overcome the problems of lack of profitability?
Operating Profit. A big issue is whether the firm looks like it can make an operating profit. If we ignore fixed costs, a firm may be able to cover its variable costs and therefore make a contribution to paying its fixed costs. In this situation, it is preferable for its creditors for a firm to keep going. If it closes down, they would lose everything. But, with an operating profit, they are at least making a contribution to the fixed costs.
In economic theory, the shutdown price are the conditions and price where a firm will decide to stop producing.
It occurs where AR <AVC
Diagram of shut down price
This theory assumes competitive markets. In reality, a firm may not shut-down because it can borrow from a bank and ride out the economic downturn.
See more: Shut-down price