Financial Distress (Meaning, Causes)| How to Calculate its Cost?

What is Financial Distress?

Financial Distress is a situation in which an organization or any individual is not capable enough to honor its financial obligations as a result of insufficient revenue. It is usually because of high fixed costs, outdated technology, high debt, improper planning and budgeting, improper management and can ultimately lead to insolvency or bankruptcy.

After this stage, the company becomes insolvent. There are very fewer chances for a company to survive after it reaches this stage. The organization has very low liquidity as it cannot repay loan installments, interest, payment to suppliers, even salary to its employees. If the organization wants to survive it needs to lower down 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. Causes of this situation are as below-

#1 – Technological Changes

If any company is not able to adapt to the technological changes and cannot upgrade itself, it will get thrown out of the market. Its market share will get drastically decrease and ultimately revenue will get lower down along with static fixed costs. 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 leads to a lower down of revenue.

For example, Lehman Brothers were 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. Due to some inappropriate decisions of CFO, the company had to file bankruptcy.

#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 fraud maker. All the key resources are not used for the benefit of the organization and led to financial distress.

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For example Fraud in Satyam Computers in 2009. Fictional expenses were booked profits were falsified. This led to the total shutdown of the company.

#4 – Improper Investment Plans

It is very necessary to maintain appropriate cash flow and fixed income from investments. If budgeting is not done correctly, either there will cash crunch or idle funds. It sometimes leaves the company taking debt in excess of what is required and ultimately led to distress.

How to Calculate the Cost of Financial Distress?

When the company is in distress, its assets don’t cost more rather 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 Debt of AAA Rated company).

Calculate the Weighted Average Cost of Debt. Example 10.5%
Take the cost of Debt of 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 shares falls or value of its assets decreases usually as a reason for cash crunch and inaccurate projections.” An example of it is US Recession in 2007-2008.

In this period the company faces severe problems in cash flow which impacts lowering down the quality of its products and services. This enables existing customers to buy from their competitors. This declines the revenue and the situation get worse. Suppliers will cut short the credit period and contract terms will get stringent. Ultimately there will be a problem in paying salary to the employees and layoffs will be done by the company. The period during which all these situations occur is known as a period of financial distress.

Factors Responsible for the Company’s Financial Distress

Factors that cause distress are divided into 2 categories – internal and external.

Internal Factors are-

Improper and ineffective demand forecast
Poor cash management
The high rate of employee layover
Unsuitable product mix
Inaccurate estimation of working capital requirement
Ill-utilization of Assets

External Factors are-

Weak contracts with suppliers
Dependency on a single supplier for raw materials
Exceptionally hike in the price of Raw material
Change in Government’s policy in terms of excess import duty, stringent trade practices, etc.

Solutions

Once the company gets into a distressing condition, it is very difficult to revive. High probability tends companies filing bankruptcy. It is very important for the management to notice the signs and take preventive actions accordingly. However, if any way out if a company comes into the period of financial distress, below are the solutions for the same-

#1 – Non-Financial Restructuring

If on analysis it is found that the company went into distressed condition because of poor management of inappropriate business plans, then it involves the restructuring board key personnel of the business is changed. Power is given to the expert and all business plans are revised. Eventually, the company can come out of the situation in a steady manner 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-

#1 – Private Workout

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

Negotiate with borrowers to curtail interest rates or waive of charges.
Avail higher high credit period
Improvise business strategies
Appropriate marketing and sales strategy to increase sales
Cost-cutting plans

#2 – File Legal Bankruptcy

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 how to restructure.
Merge with Another Company: In some cases, it is ordered by the Government to the merger with another profit-making company in the same or another industry that has enough resources to absorb losses and restructure the company.
Liquidate: If there are on the chance to revive a company, it is then ordered to liquidate the same.

Conclusion

This 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. It is important for a company to recognize signs at an early stage 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.