Financial distress

Finance is the most important aspect of any business organization. As it is, proper coordination between cash inflow and outflow is a condition, which is the financial objective of every firm. As it is, there are times, when the company undergoes through rough patches. Lack of availability of enough cash, due to various reasons can lead to financial distress.

Now, financial distress refers to a term, which is used for indicating a situation, where a company finds itself unable to address its promises to the creditors, or honors them with difficulty. Many a time, financial distress of a firm can lead to its bankruptcy. Creditors can file a bankruptcy petition against the company, in their bid to recoup a bit of what they owe to the company. This may do irreparable damage to the firm and may eventually lead to the liquidation of the company. Financial distress is generally linked with some costs in relation to the company. These costs are referred to as costs of financial distress.

A very common form of a cost of financial distress is the bankruptcy costs. Bankruptcy costs refer to the costs incurred by the firm, in relation to the bankruptcy proceedings and include expenses like legal fees, management fees, auditors' fees, as well as other payments. The cost of financial distress might occur even in case bankruptcy is avoided:

Financial distress of a company can pose serious problems, which can adversely affect the efficiency of the organization. As maximization of shareholders value as well as that of the value of the firm, take a backseat, the financial managers who are accountable to shareholders may try to transfer the value from the creditors to the shareholders. This results in a conflict of interests between the creditors and the shareholders.

When the liquidation value a firm lowers below its debt, then, it is in the interest of the shareholder for the firm to invest in risky avenues, with higher chances of earnings that increase the likelihood of the value of the firm to grow over debt. Now, risky projects, as it is, are not in the interest of the creditors.

The companies undergoing financial distress tend to go for corporate restructuring where the valuations are used in the form of negotiating tools. This difference between negotiation and the process is a distinction between corporate finance and financial restructuring.

Additional changes to an evaluation approach, irrespective of whether it is asset-based or market-based might be necessary in some cases. Apart from these there are other changes to the financial statements, which have to be made during evaluation of a company in financial distress.