DEFINITION of 'Distress Cost'
Costs that a firm in financial distress faces beyond the cost of doing business. Distress costs are broken down into two categories: ex ante (before the event) and ex post (after the event), with the event in this case being a bankruptcy. Ex ante distress costs include increased borrowing costs, since lenders will charge higher rates to firms in financial trouble. Ex post distress costs include the cost of filing for bankruptcy, hiring lawyers and accountants to work on bankruptcy proceedings, and other administrative costs associated with closing out a business.
BREAKING DOWN 'Distress Cost'
Firms with rising distress costs not only face potential bankruptcy, but also a loss of profitability as management becomes preoccupied with the threat of bankruptcy, employees show lower productivity as they worry about their jobs, suppliers charge more money up front for goods and services rather than allowing future invoicing, and customers search for healthier companies to do business with. In this sense, distress costs can lead to a vicious cycle.
Analysts reviewing a company’s financials in order to assign a value typically assume that the business will be around for the foreseeable future, and that any financial distress is temporary in nature. These assumptions allow the valuation to include a discounted cash flow from relatively far into the future.
However, if the company faces financial problems that are not temporary, this can affect the company’s terminal value. Because non-temporary financial distress is less common, it can be hard for analysts to valuate a company, since it’s significantly more difficult to understand how distress will impact future cash flows.