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We’ve all used the term before, and often – usually at the end of the month – we’ve reigned in our spending all in the name of being a tad “bankrupt”. It’s a lighthearted way of saying our pockets are a bit empty. For businesses however, there’s nothing lighthearted about the situation at all.

By definition, bankruptcy is a legal proceeding which liquidates a person or business that cannot pay its outstanding debts. All of the debtor’s assets are measured and evaluated, then used to repay a portion of the debt to relieve further liability. The process offers the individual or business a chance to start over by forgiving debts that cannot be paid, while offering creditors a chance to obtain at least some degree of repayment from available assets. Nevertheless, investors will receive a lower return on investment than initially expected – if anything at all – from a company that has filed for bankruptcy.

Take hypothetical company Pencils Inc. for example. Their sole role is manufacturing and supplying pencils. But one day, pencils fall out of fashion and everyone starts buying pens instead. As their pencil sales start to fall, Pencils Inc. find they’re not making enough money to stay afloat and being to fall into debt. Soon the company finds that they don’t have enough money to pay the company who supplies the lead for their pencils or the company who delivers their finished product to the various stationary stores who sell them. Even the landlord who rents their office space is banging down the door.

With no hope in sight, Pencils Inc. has to take drastic action, as they can’t afford to get even deeper into debt and need to pay off an angry bunch of creditors who are all owed money – including their investors. They file for bankruptcy and an administration company steps in, taking charge of Pencils Inc’s operations. The administrators then sell off all of the company’s assets, from their directors’ company cars to the pencil production equipment in their factories. The cash gained from the sell off is then paid to everybody who is owed money and the company is then either closed down or given a chance to restructure their business plan and start again - perhaps integrating pen production into their new model.

Although different countries have varying legislations and processes when it comes to bankruptcy and liquidation, in all cases, investors’ rights and opportunities change in the case of a bankruptcy filing. It’s just like holding a stock that has taken an unexpected dive – and investors must decide whether the reduced prospects of the company are worth holding onto.