Financial Distress – Meaning, Reasons, and Tips To Overcome

Financial Distress is a situation when a company is struggling to generate enough profits to meet its financial obligations. There could be various reasons for such a situation. However, some of the most common ones are illiquid assets, high fixed costs, unfavorable macro trends, etc.

Some of the signs of a company facing financial distress are being unable to pay creditors and third parties and facing challenges to pay monthly bills and salaries. When a company is in such a situation, it not only affects the higher management. The employees might also suffer from lower morale and higher stress due to the company not being able to meet its obligations.

Companies usually ensure that they do not ignore the signs of financial distress as it could take a severe turn in the long run. Every management aims to reverse any sort of financial distress and keep the organization immune from a knee-jerk reaction.

Close coordination of the management, credit managers, and other stakeholders is something that the organizations should ensure to avoid such situations. Also, making sure that there is enough cash available in the organization to meet the daily expenses helps management to wither such situations. Some companies also hire advisors to streamline expenses to ensure enough cash in the system.

Reasons for Financial Distress

Several reasons can put an organization in financial distress. However, we can club these causes under a few broad factors. These are;

Cumulative Losses

Losses on multiple fronts and continuous losses are one major factors responsible for the company going into financial distress. Often, it is seen that companies in one particular industry are more prone to financial distress during a given time. This could be due to the industry facing a downturn because of new legislation, the industry being very capital expensive, sluggish cash flow, higher capital expense, etc.

Cash Flows

Cash flow is the speed at which the money comes and leaves the business. A company might be making a profit, but the majority of its profits may be accrued. In this case, the company might not have cash at hand to run the day-to-day operations. But, it still needs to pay the monthly expenses or fixed costs. Thus, if a company does not properly manage its credit cycle, the gap between the cash inflow and outflow (paying expenses) can increase, leaving the company’s cash dry.

Any change in tax policies, custom duties, or new legislation may affect a company’s cash flow and available cash. This could lead to a higher outflow of cash to meet the daily obligations, resulting in little profit in hand. Similarly, there are instances where companies are into a legal battle with another company and are ordered to pay massive compensation or penalty.

High Expenses and Low Sales

It is understandable that if a company is low on sales and is unable to cut down on its expenses, it would lead to a cash crunch. Sales can drop due to various reasons such as cyclical factors, seasonal demands, a weak economy, and so on. However, most companies cannot cut down on their fixed and operational costs. This creates a situation of high expense and low sales. Companies could start cutting down aggressively on marketing and product branding if such a situation arises. In some severe cases, they might even start laying off employees to save the cost and avoid the situation of financial distress.

Debt Management

Credit management is a crucial part of a company to ensure the availability of cash. Often companies fall into a debt trap if they are not making enough money to settle obligations, including debt and interest on the debt. Failing to settle debt payments leads to a bad credit rating for the company. And this could further escalate the crisis as it gets difficult to get more debt. Delayed payment increases the interest burden. Mismanagement of debt might seem like a small issue initially but could end up drying the entire cash surplus of a company.

Insufficient Accounting Practices

Often, businesses with no proper accounting face situations of financial distress. Proper record-keeping could help a business identify trends and irregularities. And this allows the management to take steps early to address irregularities and avoid financial distress. Additionally, a company should also make budgets regularly. This helps the company plan in a better way and control every aspect of the business.

Financial Distress

Tips to Overcome Financial Distress

A company can avoid financial distress using the following ways;

Proper Communication

A company must always properly communicate information to all parties. For instance, if a company can’t pay the creditors on time, it should inform them the same. Also, it must tell them a tentative date when they can expect the payment. Such a gesture would ensure that suppliers don’t lose trust in the company.

Don’t Break Promises

Sticking to promises when things are favorable would ensure that parties trust you when you need their help. For instance, if you made a promise to a creditor to raise the payment, then keep it. This helps build trust, and the same creditor could help you when you need it the most.

Chase Debtors

Only when you receive money from your debtors in time will you be able to pay creditors. Thus, you should actively follow them, meaning remind them to keep the due date. However, if they are struggling, treat them the same way you would expect your creditors to treat you.

Efficient Management

If a company has efficient management, it would also have proper plans and backup plans. Moreover, well-informed management would have enough time to fix any situation of financial distress before it gets out of control.

Take Advice

Never feel shy to take the advice of the financial experts. These are usually experienced professionals who have seen such a crisis before. Also, don’t follow their advice blindly. It is entirely up to you to put their advice into action or not.

Equity Multiplier

The equity multiplier is a tool to determine the portion of debt and equity in financing assets. This helps management in keeping an eye on the rising level of debt and thereby controlling it.

Final Words

Financial distress is just an unfavorable situation that is not permanent often. A company with proper planning and implementation may be able to avoid such situations completely or come out of such situations rather quickly.

Sanjay Borad

Sanjay Bulaki Borad

MBA-Finance, CMA, CS, Insolvency Professional, B'Com

Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.

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