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 It is usually because of high fixed costs, outdated technology, high debt, improper planning and budgeting, improper management and can ultimately lead to insolvency or bankruptcy.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 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.. 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 instalments, 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. The 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 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.. 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 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. , 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.
E.g., 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 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. 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, 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. 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 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 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. , which impacts and lowers down the quality of its products and services. This enables existing customers to buy from their competitors. This 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., 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 managementCash ManagementCash Management refers to the appropriate collection, handling, & disbursement of cash for ensuring financial stability & avoiding insolvency risk.
- 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.
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 a 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 a chance to revive a company, it is then ordered to liquidate the same.
This is a situation in which the company cannot pay off its fixed costs as salary to employees, loan instalment, 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.
This has been a guide to What is Financial Distress & its Meaning. Here we discuss how to calculate the cost of financial distress, causes with examples along with its factors. You can learn more about from the following articles –