Financial Distress Cost: How it Works and How to Calculate

What Is Distress Cost?

Distress cost refers to the expense that a firm in financial distress faces beyond the cost of doing business, such as a higher cost of capital. Companies in distress tend to have a harder time meeting their financial obligations, which translates to a higher probability of default. Distress costs may extend to the need to sell assets quickly and at a loss to cover immediate needs.

How Distress Cost Works

Financial distress is a condition in which a company or individual cannot generate revenue or income because it is unable to meet or cannot pay its financial obligations. This is generally due to high fixed expenses (like overhead or salaries), illiquid assets, or revenues sensitive to economic downturns.

Firms with rising distress costs not only face potential bankruptcy but also a loss of profitability as management becomes preoccupied with darkening financial picture, employees show lower productivity as they worry about their jobs, suppliers charge more money upfront for goods and services rather than invoicing or extending credit, and customers search for healthier companies to do business with. In this sense, distress costs can lead to a vicious cycle, deepening the degree of distress.

Companies under financial distress may find it difficult to secure financing. They may also find their market value and stock price dropping significantly, customers cutting back orders, and corporate raiders circling.

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 charge higher interest 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. 

Special Considerations

Distress Cost and a Company's Valuation

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 relatively far into the future.

However, if the company faces financial problems that are not temporary it can affect the company’s terminal value. Because non-temporary financial distress is less common, it can be hard for analysts to evaluate a company, since it’s significantly more difficult to understand how distress will impact future cash flows.

Calculating Distress Cost

Looking at a company's financial statement can help investors and others determine its financial health. For example, negative cash flow under the cash flow statements is one indicator of financial distress. This could be caused by a big difference between cash payments and receivables, high-interest payments, and a drop in working capital.

The follows steps may be taken to calculate the distress cost of a company:

• Access the company's financial report.
• Add up the company's total amount of debt, including current debt (debt that has been entered into the books in the last year).
• Find out the average interest paid on debt by companies in the same space that are not in financial distress.
• Calculate for the weighted average cost of debt.
• Take that weighted average and subtract from it the cost of debt maintenance of an AAA-rated company.
• Figure the cost of financial distress in dollar terms by multiplying the financial distress cost (in percentage terms) by the total amount of debt.