What is Financial Distress?

After this stage, the company becomes insolventInsolventInsolvency is when the company fails to fulfill its financial obligations like debt repayment or inability to pay off the current liabilities. Such financial distress usually occurs when the entity runs into a loss or cannot generate sufficient cash flow.read more. There are very few chances for a company to survive after it reaches this stage. The organization has very low liquidity as it cannot repay loan installments, interest, payments to suppliers, even salary to its employees. If the organization wants to survive, it needs to lower its costs, restructure its liabilities, and revise business strategies.

Causes with Examples

It is something that happens at the time of running the business, which led to this situation. The causes of this situation are as below-

#1 – Technological Changes

If any company cannot adapt to the technological changes and cannot upgrade itself, it will get thrown out of the market. Its market share will drastically decrease, and ultimately revenue will get lower down along with static fixed costsFixed CostsFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity.read more. Gradually this will lead to financial distress.

For example, Nokia in 2012 could not adopt new technology and had to face such distress.

#2 – Improper Management

Improper management leads to inefficient decision-making and eventually a lower down of revenue.

Due to some inappropriate decisions of the CFOCFOThe full form of CFO is Chief Financial Executive, and he or she is a top level executive of the firm who is responsible for the firm’s overall finance functions and has the authority to make financial decisions for the organization. read more, the company had to file bankruptcy. For example, Lehman Brothers was the fourth-largest investment bank in America, but in September 2008, the company filed for bankruptcy. With $639 billion in assets and $619 billion in debt, the bankruptcy was the largest in history.

#3 – Fraud in the Company

Any planning of fraud may lead to diverting the organization’s objective to maximize shareholder’s wealth to the intention of the fraud maker. All the key resources are not used for the organization’s benefit and lead to financial distress.

E.g., Fraud in Satyam Computers in 2009. Fictional expenses were booked; profits were falsified. It led to the total shutdown of the company.

#4 – Improper Investment Plans

It is necessary to maintain proper cash flow and fixed income from investments. IfBudgeting is a method used by businesses to make precise projections of revenues and expenditure for a future specific period of time while taking into account various internal and external factors prevailing at that time.read more budgetingBudgetingBudgeting is a method used by businesses to make precise projections of revenues and expenditure for a future specific period of time while taking into account various internal and external factors prevailing at that time.read more is not done correctly, either there will be a cash crunch or idle funds. It sometimes leaves the company taking debt over what is required and ultimately leads to distress.

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How to Calculate the Cost of Financial Distress?

When the company is in distress, its assets don’t cost more, and its debts become more expensive. The rate of interest charged by the bank to the company is higher than what is charged to other companies in the same industry (Cost of DebtCost Of DebtCost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the discounted valuation analysis which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders.read more of AAA Rated company)..

  • Calculate the Weighted Average Cost of Debt. Example 10.5%Take the cost of Debt of an AAA-rated Company. Example 7%If the debt of the company is 100 million

Cost of Financial Distress = Difference of Rates in Step 1 * Total Debt of the company

= (10.5 – 7)% *100 million = 3.5 million

Period of Financial Distress

Technically, “A period of a company during which its market price of a share falls or value of its assets decreases usually as a reason for cash crunch and inaccurate projections.” An example of it is the US Recession in 2007-2008.

In this period, the company faces severe problems in cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more, which impacts and lowers the quality of its products and services. It enables existing customers to buy from their competitors. It declines the revenue, and the situation gets worse. Suppliers will cut short the credit periodCredit PeriodCredit period refers to the duration of time that a seller gives the buyer to pay off the amount of the product that he or she purchased from the seller. It consists of three components - credit analysis, credit/sales terms and collection policy.read more, and contract terms will get stringent. Ultimately there will be a problem paying salaries to the employees, and the company will do layoffs. The period during which all these situations occur is known as financial distress.

Factors Responsible for the Company’s Financial Distress

Factors that cause distress are divided into two categories – internal and external.

Internal Factors are-

  • Improper and ineffective demand forecastPoor cash managementCash ManagementCash Management refers to the appropriate collection, handling, & disbursement of cash for ensuring financial stability & avoiding insolvency risk. read moreThe high rate of employee layoverUnsuitable product mixInaccurate estimation of working capital requirementIll-utilization of Assets

External Factors are-

  • Weak contracts with suppliersDependency on a single supplier for raw materialsExceptionally hike in the price of Raw materialChange in Government policy in terms of excess import duty, stringent trade practices, etc.

Solutions

Once the company gets into a distressing condition, it isn’t easy to revive. High probability tends to cause companies filing bankruptcy. The management needs to notice the signs and take preventive actions accordingly. However, if any way out if a company comes into a period of financial distress, below are the solutions for the same-

#1 – Non-Financial Restructuring

Suppose on analysis, and it is found that the company went into distressed condition because of poor management of inappropriate business plans. In that case, it involves the restructuring board where key personnel of the business are changed. Power is given to the expert, and all business plans are revised. Eventually, the company can steadily come out of the situation without a permanent shutdown.

#2 – Financial Restructuring

If the company is in distress condition because of insufficient cash inflow or incapable of repaying debt, solutions for them are as follow-

In this solution, the company internally decides and plans to get restructured. A few solutions are

  • Negotiate with borrowers to curtail interest rates or waive charges.Avail higher high credit periodImprovise business strategiesAppropriate marketing and sales strategy to increase salesCost-cutting plans

  • Reorganize and Emerge: Once a company files bankruptcy, the Government, after appropriate investigation, asks debtors to waive off the partial amount payable. Asks the company to follow the necessary steps to reorganize. In and all, the power remains with the Government on restructuring.Merge with Another Company: In some cases, it is ordered by the Government to merge with another profit-making company in the same or another industry that has enough resources to absorb losses and restructure the companyRestructure The CompanyRestructuring is defined as actions an organization takes when facing difficulties due to wrong management decisions or changes in demographic conditions. Therefore, tries to align its business with the current profitable trend by a) restructuring its finances by debt issuance/closures, issuance of new equities, selling assets, or b) organizational restructuring, which includes shifting locations, layoffs, etc.read more.Liquidate: If there is a chance to revive a company, it is ordered to liquidate.

Conclusion

It is a situation in which the company cannot pay off its fixed costs as salary to employees, loan installment, payment to raw material, etc., because of improper planning of working capital, mismanagement at the top level, fraud, change in government policies, etc. A company needs to recognize signs early and take necessary preventive measures not to go into a period of financial distress. Else, it becomes very difficult to find solutions for the same.

This has been a guide to What is Financial Distress & its Meaning. Here we discuss how to calculate the cost of financial distress caused by examples along with its factors. You can learn more about from the following articles –

  • Calculate Cost of CapitalCalculate Average Fixed CostWhat is Weighted Average Cost of Capital?Corporate Profit Definition