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What is Financial Distress?

A term in Corporate and persoanl Finance used when promises to creditors of an individual or company are broken

Financial distress is a term in Corporate and persoanl Finance used to indicate a condition when promises to creditors of an individual or company are broken or honored with difficulty. Sometimes financial distress can lead to bankruptcy. Financial distress is usually associated with some costs to a company; these are known as costs of financial distress.

Cost of Financial Distress

A common example of a cost of financial distress is bankruptcy costs. These direct costs include auditors' fees, legal fees, management fees and other payments. Cost of financial distress can occur even if bankruptcy is avoided (indirect costs):

Financial distress in companies can lead to problems that can reduce the efficiency of management. As maximizing firm value and maximizing shareholder value cease to be equivalent managers who are responsible to shareholders might try to transfer value from creditors to shareholders.

The result is a conflict of interest between bondholders (creditors) and shareholders. As a firm's liquidation value slips below its debt, it is the shareholder's interest for the company to invest in risky projects which increase the probability of the firm's value to rise over debt. Risky projects are not in the interest of creditors, since they also increase the probability of the firms value to decrease further, leaving them with even less. Since these projects do not necessarily have a positive net present value, costs may arise from lost profits.

Equally, management might chose to prolong bankruptcy, which has the same effect on probabilities of a change in the firm's value. Management might also distribute high dividends to "save" money from the creditors.

Another source of indirect costs of financial distress are higher costs of capital: Short-term loans by contractors and banks are expensive and difficult to obtain.

Financial Distress: Valuation in the USA

Companies in financial distress undergo corporate restructuring where valuations are used as negotiating tools. This distinction between negotiation and process is a difference between financial restructuring and corporate finance.

Additional modifications to a valuation approach, whether it is market-, income- or asset-based, may be necessary in some instances. There are other adjustments to the financial statements that have to be made when valuing a distressed company

Options for Relieving Financial Distress in the USA

Debt restructuring is a process that allows a private or public company or a sovereign entity facing cash flow problems and financial distress, to reduce and renegotiate its delinquent debts in order to improve or restore liquidity and rehabilitate so that it can continue its operations.

If promises to creditors cannot be kept, bankruptcy is an option for both companies and individuals. In the United Kingdom, the Individual Voluntary Arrangement is a formal alternative to bancruptcy for individuals.

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