Financial Distress

Financial distress is a condition in which a company or individual cannot generate sufficient revenues or income, making it unable to meet or pay its financial obligations. This is generally due to high fixed costs, a large degree of illiquid assets, or revenues sensitive to economic downturns. For individuals, financial distress can arise from poor budgeting, overspending, too high of a debt load, lawsuit, or loss of employment.

Ignoring the signs of financial distress before it gets out of control can be devastating. There may come a time when severe financial distress can no longer be remedied because the company or individual's obligations have grown too high and cannot be repaid. If this happens, bankruptcy may be the only option.

If a company or individual experiences a period of time when it cannot pay its debts, bills, and other obligations by their due date, they are likely experiencing financial distress.

Examples of a firm's expenses that must be paid may include financing such as paying interest on debts, opportunity costs of projects, and employees who aren't productive. Employees of a distressed firm usually have lower morale and higher stress caused by the increased chance of bankruptcy, which could force them out of their jobs. Companies under financial distress may find it difficult to secure new financing. They may also find the market value of the firm falls significantly, as customers cut back on new orders, and suppliers change their terms of delivery.

Looking at a company's financial statements can help investors and others determine its current and future financial health. For example, negative cash flows appearing in the company's cash flow statement is one red flag of financial distress. This could be caused by a large disparity between cash payments and receivables, high interest payments, or a drop in working capital.

Individuals who experience financial distress may find themselves in a situation where their debt servicing costs are much more than their monthly income. These debts or obligations include items such as home or rent payments, car payments, credit cards, and utility bills. People who experience situations like these tend to go through it for an extended period of time and may ultimately be forced to relinquish assets secured by their debts and lose their home or car, or face eviction. There are multiple warning signs that could indicate a company is experiencing financial distress, or is about to in the near-term. Poor profits may point to a company that is financially unhealthy. Struggling to break even suggests a business that cannot sustain itself by generating internal funds and must instead raise capital externally.

Investopedia