What is 'Financial Distress'

Financial distress refers to a condition in which a company cannot meet, or has difficulty paying off, its financial obligations to its creditors, typically due to high fixed costs, illiquid assets, or revenues sensitive to economic downturns. A company under financial distress can incur costs related to the situation, such as more expensive financing, opportunity costs of projects, and less productive employees. Employees of a distressed firm usually have lower morale and higher stress caused by the increased chance of bankruptcy, which could force them out of their jobs.

BREAKING DOWN 'Financial Distress'

There are multiple warning signs that may indicate a company is experiencing financial distress.

Signs of Financial Distress

Poor profits indicate a company is not experiencing good financial health. Struggling to break even indicates a business cannot sustain itself from internal funds and needs to raise capital externally. This raises the company’s business risk and lowers its creditworthiness with lenders, suppliers, investors and banks. Limiting access to funds typically results in a company failing.

Poor sales growth or decline indicates the market is not positively receiving a company’s products or services based on its business model. When extreme marketing activities result in no growth, the market may not be satisfied with the offerings, and the company may close down. Likewise, if a company offers poor quality in its products or services, consumers start buying from competitors, eventually forcing a business to close its doors.

When debtors take too much time paying their debts to the company, cash flow may be severely stretched. The business may be unable to pay its own liabilities. The risk is especially enhanced when a company has one or two major customers.

Financial Distress in Large Financial Institutions

One factor contributing to the financial crisis of 2007-2008 was the government’s history of emergency loans to distressed financial institutions and markets believed “too big to fail.” This history created an expectation for parts of the financial sector being protected against losses.

The federal financial safety net is supposed to protect large financial institutions and their creditors from failure and reduce systemic risk to the financial system. However, federal guarantees may encourage imprudent risk-taking that can lead to instability in the system the safety net is supposed to protect.

Because the government safety net subsidizes risk-taking, investors that feel protected by the government may be less likely to demand higher yields as compensation for assuming greater risks. Likewise, creditors may feel less urgency for monitoring firms implicitly protected.

Excessive risk-taking means firms are more likely to experience distress and may require bailouts to stay solvent. Additional bailouts may erode market discipline further.

Resolution plans, or living wills, may be an important method of establishing credibility against bailouts. The government safety net may be a less-attractive option in times of financial distress.

RELATED TERMS
  1. Distress Cost

    Distress cost refers to the costs that a firm in financial distress ...
  2. Distress Termination

    A distress termination is when a company stops providing benefits ...
  3. Distressed Sale

    A distressed sale is a situation wherein a seller attempts to ...
  4. Asset Deficiency

    Asset deficiency is a situation where a company's liabilities ...
  5. Too Big To Fail

    "Too big to fail" is a term for a business that has become so ...
  6. Creditors' Committee

    A creditors' committee is a group of people who represent a company's ...
Related Articles
  1. Investing

    The Pros and Cons of Distressed Debt Investing

    Distressed debt investing is suitable for professional investors. Besides heavy risk factors to consider, this investment type can provide a large ROI.
  2. Investing

    How to Profit From Investing in Failing Company Debt

    Learn about the vulture funds that prey on the weakest companies by investing in their bonds.
  3. Investing

    Energy Sector in Hot Water, Defaults Keep Rising

    Fitch expects U.S. oil company default rates to pick up in 2017 despite stable oil prices.
  4. Investing

    Post Election, Buy-Side Players Want Small Caps: BofA Research

    There's a shift among buy-side players toward small caps since Trump took office
  5. Insights

    Top 6 U.S. Government Financial Bailouts

    U.S. bailouts date all the way back to 1792. Learn how the biggest ones affected the economy.
  6. Investing

    Will the Next Financial Crisis Come From Europe? (DB, CS)

    Discover why the European financial system might be in trouble, why the European Central Bank may turn to bailouts, and why that is probably a mistake.
  7. Insights

    Too Big to Fail Banks: Where Are They Now?

    In 2008, some financial companies were deemed "too big to fail." The government helped bail them out, and some of them have gone on to see big profits.
  8. Personal Finance

    Refinance Vs. Debt Restructuring: What's Best For Your Credit Score?

    Discover key differences between refinancing and restructuring debt in regard to terms, the negotiation process and effect on credit scores.
  9. Investing

    3 Global Financials Mutual Funds That Pay Dividends (TFSIX)

    Explore the financial sector, and learn about three of the highest dividend-paying global financials mutual funds available as of March 2016.
RELATED FAQS
  1. Which Creditors Are Paid First in a Liquidation?

    Find out the order in which creditors are paid during a corporate liquidation. Learn how bankruptcy claims by bondholders ... Read Answer >>
  2. Financial Risk vs Business Risk

    Understand the key differences between a company's financial risk and its business risk – along with some of the factors ... Read Answer >>
  3. When Does a Corporation Decide to Refinance Debt?

    Favorable market conditions or the strengthening of a credit rating may lead to corporate refinancing. Read Answer >>
  4. How can companies reduce internal and external business risk?

    Understand the difference between two types of operational risk – internal risk and external risk – and how companies can ... Read Answer >>
Trading Center