What Is Financial Distress?

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 costs, illiquid assets, or revenues sensitive to economic downturns.

Ignoring the signs of financial distress can be devastating for a company. There may come a time when severe financial distress cannot be remedied because the company or individual's obligations are too high and cannot be paid, and there is just not enough revenue to offset the debt. If this happens, bankruptcy may be the only option.

Understanding Financial Distress

If a company or individual experiences a period of time when it cannot pay its bills and other obligations by their due date, it is likely experiencing financial distress. Some of these expenses may include (expensive) financing, opportunity costs of projects, and employees who aren't productive. 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.

Companies under financial distress may find it difficult to secure financing. They may also find their market value dropping significantly, customers cutting back orders, and suppliers changing their terms of delivery.

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.

Individuals who experience financial distress may find themselves in a situation where their debts are much more than their monthly income. This includes home or rent payments, car payments, and credit card and utility bills. People who experience situations like these tend to go through it for an extended period of time.

Individuals who experience financial distress may be subject to wage garnishments, judgments, or legal action from creditors.

Special Considerations

Signs of Financial Distress

There are multiple warning signs to indicate a company is experiencing financial distress. Poor profits may indicate a company is financially unhealthy. 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 (or individual) 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 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 or individual may be unable to pay its own liabilities. The risk is especially enhanced when a company has one or two major customers.

Key Takeaways

  • Financial distress happens when a company or individual cannot generate revenue or income and can't meet or pay its financial obligations.
  • Financial distress is usually the last step before bankruptcy.
  • In order to remedy the situation, a company or individual may consider options such as restructuring debt or cutting back on costs.

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 who 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.

How to Remedy Financial Distress

As difficult as it may seem there may be some ways to turn things around and remedy financial distress. One of the first things many companies do is to review their business plans. This should include both its operations and performance in the market, as well as setting up a target date to accomplish all its goals.

Another consideration is where to cut costs. This may include cutting staff or even cutting back on management incentives, which can often be costly to a business' bottom line.

Some companies may consider restructuring their debts. Under this process, companies that cannot meet their obligations can renegotiate their debts and change their repayment terms in order to improve their liquidity. By restructuring, they can continue operations.

For individuals who experience financial distress, the tips to remedy the situation are similar to those listed above. Those affected may find it prudent to cut back on unnecessary or excessive spending habits such as dining out, travel, and other purchases that may be deemed a luxury. Another option may be credit counseling. With credit counseling, a counselor renegotiates a debtor's obligations, allowing him or her to avoid bankruptcy.