Financial Distress

6 Key excerpts on "Financial Distress"

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  eBook - ePub

  Corporate Financial Distress

  Going Concern Evaluation in Both International and U.S. Contexts

  • Marisa Agostini(Author)
  • 2018(Publication Date)
  • Palgrave Pivot

    (Publisher)

  bankruptcy , has progressively become a prime concern of the academic literature.

  The role of time extension is a significant recognition (Balcaen and Ooghe 2006 ), but still represents only a first step forward for defining corporate Financial Distress. Such distress implies a lengthened pathological condition for firms in which the term “financial” describes its main consequences. Therefore, corporate Financial Distress can be defined as a negative lasting situation during which a firm experiences bad financial conditions such as low liquidity, inability to pay debts, restriction on dividend distribution policy, increase in the cost of capital, reduction in access to external funding sources, and weaker credit ratings. Academic literature provides several examples of such financial consequences represented as negative (financial) accounting items, and these have been used as criteria in Financial Distress definitions. The most frequent examples are several years of negative net operating income, suspension of dividend payments, major restructuring or layoffs (Platt and Platt 2002 ), low interest coverage ratio, negative earnings before interest and taxes (EBIT), negative net income before special items, losses, selling shares to private investors, successive years of negative shareholders’ funds or accumulated losses (McLeay and Omar 2000 ), an increase in the cost of capital, a reduction in access to external funding sources, and weaker credit ratings. The negative consequences deriving from Financial Distress can be also differentiated according to the stage of enterprise life cycle . According to life cycle theory, growing capacity, access to resources, and strategies vary during a firm’s life cycle (Anthony and Ramesh 1992 ), which consists of four stages: birth, growth, maturity, and decline. In the early stages of its growth, firms are typically small, dominated by their owners (entrepreneurs), simple, informal in structure, undifferentiated, and with highly centralized power systems and considerable focus on innovation (Miller and Friesen 1984 ). Inevitably, these firms face significant uncertainty over future growth, which is manifested in higher book-to-market ratios and greater firm-specific risk (Pastor and Veronesi 2003 ). Corporate Financial Distress in the birth stage is usually related to deficiency of liquidity or cash flow difficulty (Spence 1977 , 1979 , 1981 ; Jenkins et al. 2004 ; Hasan et al. 2015 ). In the second stage, as the name suggests (i.e. growing period), firms may achieve rapid growth, acquire new (multiple) shareholders, and gain separation between ownership and control with managers assuming more decision-making responsibility (Miller and Friesen 1984 ; Mueller 1972 ). In the growing period, corporate Financial Distress is usually related to excessive financial leverage because of the perceived need to expand capital. In the last stages of the enterprise life cycle, firms are less prone to innovation and risky strategies than in their birth and growth stages. In particular, mature firms aim for the smooth functioning of the business in a well-defined market (Miller and Friesen 1984 ), while firms in decline aim to collect as much revenue from existing operations as possible (Thietart and Vivas 1984 ), in the face of encroaching stagnation and low profitability (Miller and Friesen 1984

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  eBook - ePub

  Corporate Financial Distress

  Restructuring and Turnaround

  • Alberto Tron(Author)
  • 2021(Publication Date)
  • Emerald Publishing Limited

    (Publisher)

  Chapter 1

  Corporate Distress and Financial Equilibrium: Genesis and Prognosis

  1. Introduction and Background

  Research on Financial Distress and corporate crisis management is relatively young in comparison to studies on financially sound enterprises.

  The corporate health of firms is of considerable concern for various stakeholders, such as investors, managers, policy makers and industry participants. Nowadays, the main concern of companies, regardless of their size and sector, is the threat of insolvency.

  There are several reasons for this strong focus on preventing and mitigating a corporate downturn.

  Traditionally, financial economics literature has portrayed Financial Distress as a costly event, the possibility of which is important in determining firms' optimal capital structure (Opler & Titman, 1994).

  A company under Financial Distress is a company that is struggling with promises made to its creditors. Financial Distress can be defined as the point where cash flows are lower than the firm's current obligations (Wruck, 1990).

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  eBook - ePub

  Solomon's Knot

  How Law Can End the Poverty of Nations

  • Robert D. Cooter, Hans-Bernd Schäfer(Authors)
  • 2011(Publication Date)
  • Princeton University Press

    (Publisher)

  The firm’s main stakeholders are its managers, employees, stockholders, and creditors; other stakeholders include consumers, politicians, and communities. The resolution of Financial Distress alters the status and wealth of its stakeholders. In a distressed firm, these groups have different aims: managers and employees want to keep their jobs, shareholders want a high stock price, and creditors want full repayment of debts. Different stakeholders have different powers, and they often bargain with each other in an attempt to agree on how to resolve the firm’s distress.

  Their bargaining power partly depends on the terms of a resolution that judges or other state officials will impose if the stakeholders cannot agree. The laws affecting a state-imposed resolution include bankruptcy, contracts, finance, corporations, employment, and consumer protection. The formal law, however, is less effective in many poor countries than in rich countries. In some developing countries, bankruptcy law is so ineffective and costly that firms never use it to resolve their distress. Furthermore, politics pervades the resolution of Financial Distress in some countries. The problems of distressed firms, consequently, differ significantly in developed and developing countries. General principles about distressed firms require modification in light of the special problems of developing countries.

  Causes and Cures of Financial Distress

  A firm combines capital and ideas under managers. Failure in capital, ideas, or managers can cause Financial Distress. First, consider distress caused by inadequate capital in a firm with good ideas and managers. Even good managers often miscalculate the timing of the firm’s revenues and costs. Thus start-ups in Silicon Valley often underestimate how long they will lose money before turning profitable. Similarly, a downturn in the business cycle sometimes causes a temporary cash crisis in a successful firm. Or a successful firm may experience an unanticipated shock that demands immediate cash, as when OPEC increases oil prices. If capital runs short in a firm with good ideas and good managers, the firm should refinance by seeking additional funds or restructuring its debt to slow repayment.

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  The Role of Law and Regulation in Sustaining Financial Markets

  • Niels Philipsen, Guangdong Xu(Authors)
  • 2014(Publication Date)
  • Routledge

    (Publisher)

  Initially, the scope of the definition of distress costs only covered losses from liquidating a defaulting organization. In more recent literature, the concept of distress costs is usually understood as including a wide array of costly items also covering externalities from corporate defaults to society as a whole. 15 Today, it is commonly accepted in the literature that, in addition to the (direct) costs of bankruptcy statutory reorganizations or liquidations, the concept of distress costs also includes the types of (indirect) costs, both financial and economic, that companies and contracting parties experience in the vicinity of insolvency. 16 Much of the indirect distress costs arise in the form of contractual, formal or relational, precautions incurred by claimholders as soon as default gradually appears as a likelier outcome. As Cornaggia observes: “Indeed, distress is not best considered a binary state but rather a continuum of financial health. Many firms take actions that have wealth implications for employees, customers, suppliers, creditors, and shareholders long before default or bankruptcy” (Cornaggia 2011: 358). As explained by Myers (1977), the costs of Financial Distress are incurred when the firm comes under the threat of bankruptcy, even if bankruptcy is ultimately avoided. Examples of distress costs include the losses generated by workers withholding personal investments, by clients seeking alternative sources of supplies, by input providers bargaining for shorter terms, by creditors requesting security interests or collaterals from third parties, by the losses of reputation affecting market shares and in general, etc. Bargaining and other transaction costs incurred by prospective creditors in designing protective covenants against agency conflicts are to be listed among these indirect distress costs too

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  Liquidity Risk

  Managing Asset and Funding Risks

  • E. Banks(Author)
  • 2004(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Such situ- ations are rather more rare than bankruptcy motions, but they can occur when it is clear that the firm, but for its cash strain, is a worthy franchise that can continue to create value for investors, and an interested acquirer can react to the opportunity quickly enough. Although the ending is not as dramatic as the liquidation or reorganization scenarios, it is clearly still one of Financial Distress and loss of corporate identity and independence. 103 LIQUIDITY SPIRALS AND Financial Distress Joint asset/funding liquidity risk is a significant problem, yet one that is sometimes overlooked. Indeed, it is tempting to isolate the potential loss events that can occur when problems arise either within the asset or fund- ing portfolios. But the approach can fall short, as it fails to examine the damage that can be wrought when the effects are working in tandem. To help illustrate the practical nature of such problems we consider a number of actual case studies in the next chapter. LIQUIDITY PROBLEMS 104 In the last three chapters we have explored concepts of liquidity risk and the financial losses that can arise from such exposures. In this chapter we extend our discussion by exploring a select number of “real world” case studies that help illustrate different dimensions of liquidity risk and the degree of damage that can be wrought. The examples we have chosen represent the apex of liquidity risk: finan- cial distress leading to bankruptcy. But our sampling is necessarily small. Many institutions have either failed or been rescued over the years, solely or largely as a result of liquidity problems. Still others have encountered liquidity-induced financial problems but managed to avert massive losses and even bankruptcy by taking “evasive action” at a late hour.

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  Distress Risk and Corporate Failure Modelling

  The State of the Art

  • Stewart Jones(Author)
  • 2022(Publication Date)
  • Routledge

    (Publisher)

  If you suspect your company is in financial difficulty, get professional accounting and/or legal advice as early as possible. This increases the likelihood the company will survive. Do not take a “head in the sand” attitude, hoping that things will improve – they rarely do. Warning signs of insolvency include:

  • ongoing losses
  • poor cash flow
  • absence of a business plan
  • incomplete financial records or disorganized internal accounting procedures
  • lack of cash-flow forecasts and other budgets
  • increasing debt (liabilities greater than assets)
  • problems selling stock or collecting debts
  • unrecoverable loans to associated parties
  • creditors unpaid outside usual terms
  • solicitors’ letters, demands, summonses, judgements or warrants issued against your company
  • suppliers placing your company on cash-on-delivery terms
  • special arrangements with selected creditors
  • payments to creditors of rounded sums that are not reconcilable to specific invoices
  • overdraft limit reached or defaults on loan or interest payments
  • problems obtaining finance
  • change of bank, lender or increased monitoring/involvement by financier
  • inability to raise funds from shareholders
  • overdue taxes and superannuation liabilities
  • board disputes and director resignations, or loss of management personnel
  • increased level of complaints or queries raised with suppliers
  • an expectation that the “next” big job/sale/contract will save the company.

  Once again, statistical learning methods, particularly high dimensional machine learning methods, can combine and weight many such risk factors to produce an accurate probability forecast of a firm’s capacity to continue as a going concern or become insolvent.

  There are many other international corporate disclosure regulations that are under active consideration relating to business risk assessments. For instance, Exposure Draft ED/2021/6 Management Commentary published by the International Accounting Standards Board proposes a comprehensive framework that entities could apply when preparing management commentary that complements their financial statements. The proposals represent a major overhaul of IFRS Practice Statement 1 Management Commentary

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