What Is a Distress Price?
A distress price is when a company chooses to mark down the price it charges for an item or service instead of discontinuing the product altogether. Such decisions are usually made during difficult market conditions when the sale of a particular item or service has slowed dramatically, and the company is unable to sell enough to cover the fixed costs associated with doing business.
Utilizing a distress price is meant to spur sales to generate enough cash flow to at least cover a company's operating costs.
- A distress price refers to the price at which a company marks down a product or service instead of discontinuing it.
- It is the minimum price at which a company can sell an item and make a profit.
- Distress prices are often made during difficult market conditions in an attempt to spur sales and at least cover fixed costs.
- A company may discontinue the product if it cannot be sold at a price greater than its variable cost of production.
Understanding Distress Prices
Sometimes a company will choose to mark down an item's price rather than discontinue operations completely. The rationale is that even at a distressed price, incoming revenue can at least help with covering the fixed, unavoidable costs associated with running the business, such as rent, insurance, salaries, and interest.
As opposed to a sale at a loss, a distress price is the variable cost of an item—corporate expenses that change in proportion to production output, such as labor, raw materials, and energy—with a small markup included. In short, it is the minimum price a company can manufacture and sell an item and still turn a profit.
If the item cannot be sold at a price greater than its variable cost of production, the company will likely opt to discontinue it instead.
Companies that employ distress pricing cannot afford to adopt such initiatives as part of their long-term business model. Distress pricing is meant to be temporary while it shifts production, changes operations, or waits for market conditions to improve.
Distress pricing, also referred to as a fire sale, may be applied to consumer goods as well as investable assets such as property and securities.
Example of a Distress Price
A nasty recession has just hit the economy, triggering mass unemployment and prompting consumers to tighten their budgets. Retailer ABC struggles to offload its products at regular prices, leading to a serious decline in revenue. With no money coming in, Retailer ABC risks defaulting on bills and going out of business unless a solution is found quickly.
Management responds by initiating a fire sale on some goods hardest hit by cratering demand. One of the items that falls into this category costs the company $1.50 to produce and get onto the shop floor. After considering other expenses associated with selling the item, such as cashier wages, rent, insurance, etc., management concludes that offloading the product for anything less than $2.50 would represent a loss.
In healthier times, Retailer ABC charged $6.50 for that same item. Now, it agrees that a price of $3.50, a 46% discount, should offer customers enough incentive during this difficult period, while still enabling the company to generate a profit.
A $1 gain is nowhere near as lucrative as a $4 one; however, it will at least result in some income coming in, rather than nothing at all, and keep the company afloat until confidence returns and consumer spending picks up again.
Distress Price vs. Distressed Sale
A distress price is sometimes mistakenly confused with a distressed sale. The two terms have different meanings, with a distressed sale referring to property, stocks, or other assets that are sold in an urgent manner, usually under unfavorable conditions for the vendor.
Distressed sales often occur at a loss because funds tied up in the asset are needed within a short period of time for another, more pressing debt. Funds gleaned from a distressed sale are often used to pay for medical expenses or other emergencies.
For example, an individual may have to quickly sell a property to pay a large and unexpected hospital bill. They are motivated to sell promptly to cover that debt and therefore price the property aggressively to quickly attract buyers.
What Are Distressed Securities?
Distressed securities refer to stocks, bonds, or other investments that are being sold at a discount because the issuer is perceived to be in serious financial trouble. A company at risk of bankruptcy or liquidation might see a steep drop in its share price, as stockholders seek to recoup as much of their investment as possible.
What Are the Tax Implications of a Distress Sale?
Property owners may owe taxes on a distress sale, even if they sell their property at a capital loss. This may be the case in cases of foreclosure or deed-in-lieu-of-foreclosure transactions, where debt is forgiven as part of the transaction. It is worth consulting with a professional tax advisor before considering such a sale.
What Is Distressed Debt?
Distressed debt means the debt of people or companies who are very unlikely to repay all of their creditors. Because the lender is very unlikely to see full payment, distressed debt tends to sell at a steep discount from face value. Distressed corporate bonds can be an attractive asset to some investors, because it gives the bondholders a say in any future reorganization of the distressed company.