In finance, consider a company to be in financial distress when it is having difficulty making payments to creditors. Financial distress may lead to bankruptcy. The more debt a company uses to finance its operations the more it is at risk of experiencing financial distress. There are several costs associated with financial distress, including bankruptcy costs, distressed asset sales, a higher cost of capital, indirect costs, and conflicts of interest.
The more debt a company takes on, the more it risks being unable to meet its financial obligations to creditors. A highly leveraged firm is more vulnerable to a decrease in profitability. Therefore, a highly levered firm has a higher risk of bankruptcy.
Bankruptcy costs vary for different types of firms, but they typically include legal fees and, losses incurred from selling assets at distressed fire-sale prices, and the departure of valuable human capital. The way to measure bankruptcy cost is to multiply the probability of bankruptcy by the expected cost of bankruptcy. A company should consider the expected cost of bankruptcy when deciding how much debt to take on.
There are also several indirect costs associated with financial distress. When a company is experiencing financial distress, conservative managers may cut down on research and development, marketing research, and other investments to spare cash. The firm may also incur opportunity costs if trepid managers pass on risky corporate projects.
Also, financial distress can affect a firm’s reputation. A company in financial distress may lose customers, be forced to pay a higher cost of capital, receive less favorable trade credit terms from suppliers, and be vulnerable to tactics from aggressive industry competitors.
Financial distress can incur costs associated with the conflicting self-interests of creditors, managers, and owners.
When a company in financial distress is confronted with a risky investment opportunity, creditors would prefer the company not engage in the risky investment – they would rather the company preserve its assets so they will be able to collect what’s owed to them in the event of default or bankruptcy.
Investors, or owners, on the other hand, would prefer the company to go forward with the risky investment. If the company foregoes the investment, owners don’t benefit. If the company does go for the risky investment, owners have at least some upside gain potential.
While managers may be either conservative in the face of a risky opportunity in order to try to preserve their jobs, or they may be more inclined to take the risk if they side with the shareholders or see the opportunity as a chance to increase personal gain.
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Higgins, Robert C. “Analysis for Financial Management,” McGraw-Hill Irwin, New York, 2007.