As the name suggests, this is a distressing situation for a company wherein it is not able to fulfill its financial obligations(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. If financial distress cannot be relieved, it can lead to bankruptcy. Financial distress is usually associated with some costs to the company; these are known as costs of financial distress.
What do financial obligations mean here?
Payment to creditors, repayment of loans, salary distribution to employees, manager’s fees, and so on.
What leads to such a situation?
When a company is unable to generate enough revenue through its operations to the point that it cannot even break, we say that the company is in financial distress. Now, what does this mean?
Break-even means that the company is earning enough to pay off its expenses. But, when the company fails to do, a situation of financial distress occurs.
A common example of a cost of economic distress is bankruptcy costs. These direct costs include auditors’ fees, legal fees, management fees, and other payments. Cost of economic distress can occur even if bankruptcy is avoided (indirect costs).
Economic distress in companies requires management attention and might lead to reduced attention on the operations of the company.
Another source of indirect costs of economic distress is higher costs of capital as usually banks increase the interest rates if a state of economic distress occurs.
There are various reasons why a company cannot generate enough revenue. Let us have a look at a few of them.
Cash to Cash Cycle
The period in which the company takes money from suppliers, produces goods, sells, and receives money from buyers is known as the cash-to-cash cycle. This is an important determinant for financial management. The reason is, that a business must have enough liquid money(cash) to take care of the day-to-day transactions.
A company must strive that it will get its money from debtors faster than the company needs to pay off its creditors.
For, G Ltd. has to pay off its suppliers(creditors) after 3 months while it receives money from its debtors after 3.5 months. This is not a good scenario. The company will always face a shortage of cash and will always need to borrow loans for timely repayments.
Poor management decisions (Financial Distress)
Just like in the previous scenario, there are numerous decisions and strategies to be determined by financial managers. Failure to do so always adds to debt generation. This means that a heap of loans is constantly accumulating. In even worse situations, even the capital is eroded (used up) to pay off the debts and other financial obligations leaving the shareholders(owners) baffled.
Inability to cope with competition
The competition in all industries is cut-throat. People change their purchasing decisions in seconds. The majority of the population follows trends and buzz, I mean, just look at Instagram reels. Companies need to put in a tremendous amount of effort to maintain their presence and relevancy.
The ability to adapt to the latest technology and have an excellent marketing team is a prerequisite for remaining in the market. Or else the company will not be able to attract enough customers and eventually lose its market share. Henceforth, the company will not be able to generate enough profits leading to financial distress.
Financial distress is a precursor to bankruptcy. Surely, the company will shut down after this unless the management takes drastic action to improve, like restructuring its assets and liabilities.