Corporate Finance

What is corporate distress? What are the factors contributing to corporate distress?

Corporate distress is a state in which a corporate entity is unable to generate enough revenue or income to fulfil or pay its financial obligations. This is normally because of huge fixed costs, a high percentage of illiquid assets in the business, or revenue that is susceptible to economic downturns.

Ignoring the signals of corporate distress before they become too severe and out of control might be disastrous. There may come a moment when severe corporate distress cannot be alleviated because the company’s outstanding liabilities have become and grown too large to be repaid. If this occurs, bankruptcy may be the only option available.

Understanding corporate distress

A corporation is likely to be in financial difficulty if it is unable to pay the debts, bills, or other commitments by the due date. Financing costs, such as paying interest on short-term and long-term debts, opportunity costs of projects, and employees who aren’t productive are all examples of expenses that must be paid by a company. Employees of a distressed company typically have lower levels of morale and greater stress as a result of the increased likelihood of bankruptcy, which might push them out of their jobs.

It may be difficult for a company in financial difficulties to obtain new funding. Customers may cut back on new orders, and suppliers may also adjust delivery terms & conditions, resulting in a dramatic drop in the firm’s market value.

Investors and others can learn about a company’s current and future financial health by looking at its financial statements. One red flag indicating financial instability is the presence of negative cash flows in the company’s cash flow statement. A wide gap between cash payments and receivables, high-interest payments, or a decrease in working capital could all contribute to this.

Factors contributing to corporate distress

Corporate distress may arise due to a number of internal and external factors if they are ignored.

• Poor profitability

There are a number of indicators that a company is experiencing or will experience financial trouble in the near future. Profitability issues may indicate a company’s deteriorating financial health. Struggling to break even denotes a company that is unable to sustain itself from internal funds and needs to seek external funding. This raises the company’s business risk and reduces its creditworthiness in the eyes of lenders, suppliers, investors, and banks. A corporation (or an individual) that has restricted access to funds is more likely to collapse.

• Declining sales

Sales that are declining or growing slowly suggest that demand for a company’s products or services is not meeting expectations based on its current business strategy. Consumers may no longer be satisfied with the firm’s offerings if expensive marketing strategies result in only a little growth, and the company may be forced to close down. Similarly, if a firm provides poor quality items or services, customers will begin to purchase elsewhere, eventually causing the business to close its doors.

• Lag in payments by debtors

Cash flow can be majorly affected if debtors take an unreasonable amount of time to settle their debts to the company. It’s possible that a company or an individual won’t be able to cover their own debts. When a company just has one or two key customers, the risk increases dramatically.

• Mismanagement

Many times, managerial failures are frequently the cause of a company’s financial distress. By borrowing money to fuel growth, top leaders may overextend the organization financially. But if the borrowed funds do not result in improved revenues or profits in a timely manner, the company may find it difficult to meet its debt repayment obligations.

• High debt

Loans, credit cards, debentures, and other forms of debt can be extremely risky for a small business. The downside of credit arises when it comes the time to repay the debts, even though most firms rely on some sort of credit to receive the money they require to begin. A company’s capacity to compete is harmed when it spends the majority of its cash flow on debt repayment rather than expanding its client base or adding new employees.

• Inaccuracy in projections

The majority of business owners are natural optimists. They recognize that their beliefs have the capacity to influence society, and they approach their actions with optimism. On the other side, their optimism may induce individuals to overestimate their potential earnings while underestimating future expenses. Exaggerated expectations can often lead to poor business decisions based on incorrect information. Therefore, the proprietors must make accurate income and cost predictions in order to keep their business dreams alive.

• Excessive competition

There is no greater threat, shock, or fear to a corporation than a quality product in the hands of a competitor. Numerous businesses have lost their market share to competitors as a result of competition and have had to close their doors.

• Poor marketing strategies

Poor marketing or pricing decisions might also contribute to a company’s financial difficulties. An expensive advertising plan that fails, or ineffective alterations to a product or pricing structure that result in a decline in sales, are two major drivers of financial problems. Even the most successful companies may make mistakes like this.

• Economic conditions

Even the most well-off company might face financial difficulties. Because business challenges can emerge due to a variety of factors, some of which are entirely beyond a corporation’s control. For example, a sudden and unplanned slowdown in the economy could result in a big drop in a company’s revenue. Because of the quarantine and lockdown imposed in the aftermath of the COVID-19 epidemic^[1], many physical stores that had previously generated a steady stream of revenue unexpectedly saw their earnings collapse to zero.

Similarly, a business may have taken out a significant loan with a variable or adjustable rate of interest. In that case, a considerable increase in interest rates in the market can significantly increase the cost of repaying the loan, resulting in financial difficulties for the company.

Options for remedy

When a financial crisis arises, it must be addressed as soon as possible to prevent the situation from worsening. If such financial problems are not addressed quickly, they frequently worsen and convert into larger financial difficulties. A company or business that is experiencing financial difficulties, for example, may see its credit score to decline. As a result, lenders would charge them higher interest rates, making it more difficult for them to borrow money to help them get through a period of lower income or revenue.

There are methods to turn things around and get out of financial trouble, no matter how impossible it may appear. Many businesses do a review of their business plans as one of the initial steps. This should encompass both its internal operations and market performance, as well as fixing a deadline for achieving all of its objectives.

Budgeting based on unrealistic sales, revenue, and cost estimations can lead to financial difficulties that you may not be able to bear. When sales are lower, it is not always feasible to cut expenses, especially if a business has committed to contracts based on inaccurate budget projections. These incorrect budget assumptions result in incorrect pricing strategies and cash flow warning signals. Therefore, to overcome this, a business can prepare multiple copies of the annual budget to show what will happen at various sales and expense levels so it can plan for inaccurate projections.

Another thing to think about is where you can save money or cut costs. This could entail laying off employees or reducing managerial incentives, both of which can be detrimental to a company’s bottom line.

When adapting during a downturn, having a solid understanding of your company’s liquidity and cash flows is the number one priority. Although a crisis of COVID-19 may appear to be a short-term economic downturn, it might lead to a much longer, more serious recession. Examine the history of industry cycles in your field to determine the severity and duration of the downturn. Examine your fixed vs. variable costs and compute contribution margins (not gross margins) for each scenario. During periods of high volatility, it is critical to run multiple scenarios concurrently and develop a contingency plan for each. Make a detailed timeline for putting each plan into action.

Some companies may want to restructure their debts. Companies that are not able to meet their obligations might use this process to renegotiate their debts and adjust their repayment terms in order to enhance their liquidity. They can keep operating via restructuring.

Takeaway

When an organization’s revenues or income no longer meet or pay for its financial obligations, it is said to be in ‘corporate distress’. This corporate or financial distress is often a precursor to bankruptcy and can have long-term consequences for one’s creditworthiness. To combat the situation, a company may consider options such as debt restructuring or the implementation of cost-cutting measures.

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