Financial Distress Costs

Financial Distress Costs

See Also:
Financial Accounting Standards Board
Financial Instruments
Hedging Risk
Financial Ratios
Finance Beta Definition

Financial Distress Costs

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.

Bankruptcy Costs

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.

Indirect Costs of Financial Distress

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 and Conflicts of Interest

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.
Download your free External Analysis whitepaper that guides you through overcoming obstacles and preparing how your company is going to react to external factors.
financial distress costs
[box]Strategic CFO Lab Member Extra
Access your Projections Execution Plan in SCFO Lab. The step-by-step plan to get ahead of your cash flow.
Click here to access your Execution Plan. Not a Lab Member?
Click here to learn more about SCFO Labs[/box]
financial distress costs
Source:
Higgins, Robert C. “Analysis for Financial Management,” McGraw-Hill Irwin, New York, 2007.

ARTICLES YOU MIGHT LIKE

The Struggles of Private Company Accounting

Hiring the right accountant  When I meet a business owner operating at a successful $10 million in revenue, they often mention, “My CPA”… I immediately know that CEO/Entrepreneur is referring to their Tax CPA.  That is because one thing that all Entrepreneurs have in common is that they must file a tax return.  So, from

Read More »

IN CRISIS? GET A STRATEGIC CFO! – CEO Blindspots Podcast

Friend of the firm, Birgit Kamps, recently had Strategic CFO President, Dan Corredor, as a guest on her podcast, CEO Blindspots. CEO BLINDSPOTS HOST: Birgit Kamps. She was speaking five languages by the age of 10, and lived in five countries with her Dutch parents prior to becoming an American citizen. Birgit’s professional experience includes starting

Read More »

SHRM calls ICHRA the 401K for Group Health Benefits

Fed-up with group health insurance? ICHRA is the new way to offer great health benefits and avoid ACA penalties, SHRM calls it the 401K for group health benefits.  In 2020 the Department of Labor, HHS and IRS changed the rules for employer health benefits. They changed the Affordable Care Act mandates and penalties for every

Read More »

JOIN OUR NEXT SERIES

Financial Leadership Workshop

MARCH 28TH-31ST 2022

SHARE THIS ARTICLE

JOIN THE NEXT STRATEGIC CFO™ SERIES

Strategic CFO™ Financial Leadership Workshop
The Art of the CFO®

Days
Hours
Min
Sec

September 12-15th 2022