Financial Distress: Definition, Signs, and Remedies

What Is Financial Distress?

Financial distress is a condition in which a company or individual cannot generate sufficient revenues or income, making it unable to meet or pay its financial obligations. This is generally due to high fixed costs, a large degree of illiquid assets, or revenues sensitive to economic downturns. For individuals, financial distress can arise from poor budgeting, overspending, too high of a debt load, lawsuit, or loss of employment.

Ignoring the signs of financial distress before it gets out of control can be devastating. There may come a time when severe financial distress can no longer be remedied because the company or individual's obligations have grown too high and cannot be repaid. 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 debts, bills, and other obligations by their due date, they are likely experiencing financial distress.

Examples of a firm's expenses that must be paid may include financing such as paying interest on debts, 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 new financing. They may also find the market value of the firm falls significantly, as customers cut back on new orders, and suppliers change their terms of delivery.

Looking at a company's financial statements can help investors and others determine its current and future financial health. For example, negative cash flows appearing in the company's cash flow statement is one red flag of financial distress. This could be caused by a large disparity between cash payments and receivables, high interest payments, or a drop in working capital.

Individuals who experience financial distress may find themselves in a situation where their debt servicing costs are much more than their monthly income. These debts or obligations include items such as home or rent payments, car payments, credit cards, and utility bills. People who experience situations like these tend to go through it for an extended period of time and may ultimately be forced to relinquish assets secured by their debts and lose their home or car, or face eviction.

Signs of Financial Distress

There are multiple warning signs that could indicate a company is experiencing financial distress, or is about to in the near-term. Poor profits may point to a company that is financially unhealthy. Struggling to break even suggests a business that cannot sustain itself by generating internal funds and must instead raise capital externally. This increases 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.

Declining sales or poor sales growth indicates that demand is not there for a company’s products or services based on its existing business model. When expensive marketing campaigns result in no growth, consumers may no longer be satisfied with their offerings and the company may be forced to close down. Likewise, if a company offers poor quality products or services, consumers will start buying from competitors, eventually forcing a business to close its doors as well.

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 just one or two major customers.

How to Remedy Financial Distress

As difficult as it may seem, there are 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's 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. Debt consolidation is another method for reducing monthly debt obligations by rolling high-interest debts such as credit cards into a single, lower-interest personal loan.

Distress in Large Financial Institutions

One factor contributing to the financial crisis of 2007–2008 was the government’s history of providing emergency loans to distressed financial institutions in markets believed "too big to fail." This created an expectation for parts of the financial sector being protected against losses, known as moral hazard.

The federal financial safety net is supposed to protect large financial institutions and their creditors from failure to reduce systemic risk to the financial system. However, these guarantees also encouraged imprudent risk-taking that caused instability in the very system the safety net was 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 corporate "living wills" may be an important method of establishing credibility against bailouts. The government safety net may then be a less attractive option in times of financial distress.