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Every economic system needs mechanisms to ensure the optimal use of resources. Bankruptcy is the primary instrument for reallocating means of production from inefficient to efficient firms.
Theoretically, bankruptcy shakes out the bad apples from sectors in difficulty and allows profitable groups to prosper. Without efficient bankruptcy procedures, financial crises are longer and deeper.
A bankruptcy process can allow a company to reorganise, often requiring asset sales, a change in ownership and partial debt forgiveness on the part of creditors. In other cases, bankruptcy leads to liquidation – the death of the company.
Generally speaking, bankruptcy is triggered when a company can no longer meet its short-term commitments and thus faces a liquidity crisis. Nevertheless, the exact definition of the financial distress leading the company to file for bankruptcy may differ from one jurisdiction to another.
Bankruptcy is a critical juncture in the life of the firm. Not only does the bankruptcy require that each of the company's stakeholders make specific choices, but the very possibility of bankruptcy has an impact on the investment and financing strategies of healthy companies.
Companies do not encounter financial difficulties because they have too much debt, but because they are not profitable enough. A heavy debt burden does no more than accelerate financial difficulties.