What is a Default?

Default is the failure by a debtor to make a principal or interest payment in a timely manner. The result can be the loss of collateral or even a bankruptcy filing by the debtor. This situation occurs when the cash inflows of a business are exceeded by its cash outflows, leaving no cash with which to make debt payments. A default can also arise when a borrower breaches a loan covenant, such as when it reports a debt-to-equity ratio that is worse than the minimum level set by the lender.

What are the Signs of an Impending Default?

Signs of an impending default usually involve a combination of financial distress indicators and deteriorating fundamentals. Here’s what to watch for:

Declining cash flows and earnings. If a company’s earnings consistently fall short of expectations or if cash flow becomes tight, it signals financial stress. This often forces companies to rely on new debt to cover expenses.
High debt-to-equity ratio. A high ratio means the company is heavily leveraged, meaning they have more debt relative to shareholder equity, which raises the risk of default during downturns.
Delayed payments. Companies nearing default may delay payments to suppliers, employees, or creditors. Missed interest payments are often a precursor to default.
Asset sales or layoffs. Emergency actions like selling off core assets, laying off employees, or cutting dividends to raise cash can indicate that the company is struggling to meet its obligations.
Credit downgrades. Credit rating agencies will downgrade companies with a deteriorating financial outlook, which increases borrowing costs and limits their access to credit.