What is Financial Distress?

Financial distress occurs when an organization is unable to pay its creditors and lenders. This condition is more likely when a business is highly leveraged, its per-unit profit level is low, its breakeven point is high, or its sales are sensitive to economic declines. To get out of the situation, managers may be forced to sell assets on a rush basis, lend their own money to the firm, and/or eliminate discretionary expenditures. Another problem is that employees will be much more likely to look for work elsewhere, so there is a rapid decline in the level of institutional knowledge within the business.

Characteristics of Financial Distress

There are a number of indicators of financial distress that an outsider can use to judge the financial situation within a business. They include the following:

Difficulty paying bills. A business struggles to pay operating expenses, suppliers, or creditors.
Overdrawn bank accounts. A business has frequent overdrafts or reliance on short-term borrowing.
High leverage. A business has a heavy reliance on debt to finance operations or investments. This leads to increased financial strain from interest payments on outstanding loans.
Declining profits. A business experiences decreasing revenues and profit margins. This may be due to higher costs that outpace revenue growth.
Asset deterioration. A business liquidates its assets in order to generate cash.
Credit issues. A business has poor credit ratings, while suppliers require upfront payments or stricter credit terms.
Financial statement indicators. A business reports negative working capital, declining equity, and/or debt covenant violations.
Increased turnover. A business has an increasing level of turnover among its employees and customers.

Understanding these characteristics can help you identify early warning signs of financial distress.

Early Signs of Financial Distress

Any business manager wants to know when its business partners are experiencing financial distress, so that they can take steps to mitigate the potential losses arises from this situation. The following are all early signs of financial distress:

Cash flow problems. A business partner may not be able to pay its bills on time. This is especially concerning when the payment interval continues to increase over time, since it indicates that the firm is quickly running out of cash.
Employees are leaving. Your recruiting contacts may tell you that employees are leaving the firm. This could be due to the organization’s inability to provide them with adequate pay raises or benefit packages, or perhaps because the employees understand that their employer is running out of cash, so they should leave now.
Sales are declining. There may be news in the industry that a business is losing customers. This may be because it does not have sufficient cash to fund its operations, resulting in slow deliveries to customers.

Responses to Financial Distress

When a business is in financial distress, other parties will typically engage in several actions to reduce their risk in relation to that business. One option is for a supplier to insist on the return of any unpaid inventory. Suppliers may also require that any additional payments be made with cash on delivery (COD) terms. Suppliers could also start to charge interest and penalties on overdue payables. Lenders will also act in a conservative manner, such as not extending any additional loans. Customers may cancel their orders or will not place new orders, while competitors will try to steal away customers.

Financial Distress and Liquidation

Financial distress is common just before a business declares bankruptcy. If the level of distress is high, the firm may be forced into immediate Chapter 7 liquidation, rather than attempting to work out a payment schedule with creditors and lenders.