Financial distress

Financial distress is a term in Corporate Finance used to indicate a condition when promises to creditors of a company are broken or honored with difficulty. Sometimes financial distress can lead to bankruptcy. Financial distress is usually associated with some costs to the company and these are known as Costs of Financial Distress.

Cost of Financial Distress

A common example of a cost of financial distress is bankruptcy costs. These direct costs include auditors' fees, legal fees, management fees and other payments. But cost of financial distress can occur even if bankruptcy is avoided (indirect costs):

Financial distress in companies can lead to problems that can reduce the efficiency of management: As maximizing firm value and maximizing shareholder value cease to be equivalent managers who are responsible to shareholders might try to transfer value from creditors to shareholders.
The result is a conflict of interest between bondholders (creditors) and shareholders. As a firms liquidation value slips below its debt, it is the shareholder's interest for the company to invest in risky projects which increase the propability of the firms value to rise over debt. Risky projects are not in the interest of creditors however since they also increase the propability of the firms value to decrease further, leaving them with even less. Since these projects do not necessarily have a positive net present value costs may arise from lost profits.
Equally, management might chose to prolong bancruptcy, which has the same effect on propabilities of a change in the firms value. Management might also distribute high dividends to "save" money from the creditors.

Another source of indirect costs of financial distress are higher costs of capital: Short-term loans by contractors and banks will be expensive and hard if not impossible to get.

Valuation of a distressed company

Companies in financial distress undergo corporate restructuring where valuations are used as negotiating tools. This distinction between negotiation and process is a difference between financial restructuring and corporate finance.

Additional modifications to a valuation approach, whether it is market-, income- or asset-based, may be necessary in some instances. There are other adjustments to the financial statements that have to be made when valuing a distressed company. [Joseph Swanson and Peter Marshall, Houlihan Lokey and Lyndon Norley, Kirkland & Ellis International LLP (2008). A Practitioner's Guide to Corporate Restructuring, Andrew Miller’s Valuation of a Distressed Company page 24. ISBN: 9781905121311]

Debt Restructuring

Debt restructuring is the process that allows a private or public company - or a sovereign entity - facing cash flow problems and financial distress, to reduce and renegotiate its deliquent debts in order to improve or restore liquidity and rehabilitate so that it can continue its operations.

Individuals and Households

In a more general sense, financial distress is a reduction in financial efficiency that results from a shortage of cash. This concept applies even to individuals and households. Imagine that you have no preference about what kind of toilet paper you use, so you simply buy the cheapest toilet paper available. This means you go to a big box store every few months and buy in bulk. But to take advantage of the lowest price, you have to buy a large quantity and spend several dollars. Now imagine that you were short on cash as your toilet paper was running low. You cannot afford to buy in bulk, so you buy a small package at a convenience store. In order to minimize your total cash outlay, you accept a higher unit cost. That's what happens in financial distress. You're too poor to live cheaply.

References

External links

* [http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page40.htm Indicators and Sources of Financial Distress]
* [http://pages.stern.nyu.edu/~ealtman/Zscores.pdf "Predicting Financial Distress of Companies: Revisiting the Z-Score and Zeta® Models by Edward Altman"]
* [http://www.finance.ox.ac.uk/file_links/finecon_papers/2004fe07.pdf "Financial Distress, Bankruptcy Law, and the Business Cycle by Javier Suarez and Oren Sussman"]
* [http://papers.ssrn.com/sol3/papers.cfm?abstract_id=945425"The Costs of Financial Distress across Industries by Arthur Korteweg"]


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