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.