An Overview of Financial Distress
Financial Distress refers to the financial situation of an entity (whether that is a company or individual) which is struggling or unable to pay their bills. More often than not, a lack of capital to finance loan payments to creditors is the main cause of financial distress. This can happen for many reasons and can be challenging for all parties involved. The COVID-19 pandemic has brought this topic to the forefront of corporate finance once again, with over 550,000 businesses in significant distress. [1] This article will explore how financial distress comes about as well as looking at the variety of responses that can arise as a result.
How Does It Happen?
There are many different ways in which a firm can become financially distressed. Although, generally speaking, these ways can be categorised into three areas.
Firstly, the economic or industry environment can play a huge role in how financially sound an entity is. If the economic environment is prosperous, then we can expect firms to also reap the rewards and move further away from any type of financial distress. On the other hand, economic uncertainty can impact a firm massively in a number of ways. Uncertainty in the economy connotes an aggregate decrease in demand as a result. Consequently, the revenues of firms decrease and there is a lack of cash inflow. This reduces the amount of capital that firms have to pay their overheads (such as rent, insurance, loans etc.) and can potentially lead to a struggle in getting these bills paid. Therefore, poor economic or industry conditions can certainly increase the risk of a firm experiencing financial distress.
The second way in which a company may become financially distressed would be because of business management. This looks at the methods used by the company to increase revenue, such as new product ranges. However, sometimes the methods used in making this money can backfire. In other cases, it can be a lack of action taken by the company which leads to their demise. This was the case for Motorola, who were once one of the major players in the cellular phone industry [2] A lack of product development in the mid-2000s allowed the likes of Blackberry and Apple to take control of the market. Confidence in the company fell to the extent that shares in Motorola plummeted by 90% between 2006 and 2009 highlighting one of the biggest business errors ever. [3] Therefore, it is clear that poor business management can really negatively impact a company. In the case of Motorola, little product development meant a lack of sufficient revenue to keep the company going at the levels that it once operated. Although the company is now a subsidiary of Lenovo, it has never returned to the highs experienced in the 1980s and 1990s. [4]
Finally, the financial management of a company can play an enormous role in whether a firm is successful, or if it is financially distressed. Financial management involves ensuring that there is sufficient cash on hand at the company to meet their current obligations. A company can be performing well in a market, and still become financially distressed due to a lack of quality in managing their finances. Ultimately, if the money on hand is insufficient to pay its current obligations, it spells trouble for the company.
What Can It Lead To?
As financial distress is a broad term, the consequences of it for companies are endless. The final strategy for a financially distressed firm would be to wind up the company, though there are many policies which can be implemented before this to avoid having to shut up shop completely. Generally, it comes down to how long the company is distressed for which dictates what response the company takes to solve the problem. There is a huge list of turnaround strategies which may be used, but these are some of the more prominent choices.
Firstly, a firm may look to mitigate risk and distress by expanding in size. This looks to increase levels of production and sales by merging or acquiring other companies. However, this expansionist policy is very expensive, and may only prevent financial distress in the short term.
Another policy used would be to contract the operations of the business. This is where a company chooses to focus on its most profitable ventures, whilst closing or selling-off the less profitable portions of the business. This is a method of cost reducing which looks to decrease cash outflow, so present obligations can be met.
Sometimes a firm may use financial policies (such as reducing annual dividend payments or debt restructuring) to have more cash on hand to pay for their present obligations. Though this can be a quick solution to access cash, many investors use dividends and debt restructuring news as a signalling function. This means that a reduction in dividend payments, or news of debt restructuring, may lead to a fall in the share price of the company because the market believes that the company is experiencing problems. In this way, a company may try to avoid this policy.
Other than winding up the company altogether, the final main policy would be to change managerial control. This normally goes alongside other forms of restructuring, but a company may look to remove current managers as they may have played a role in distressing the company. Thus, new management may be preferred.
Financial Distress at Carillion
The bankruptcy and eventual closure of UK construction firm Carillion in 2018 is an excellent example of a firm experiencing financial distress to the point of no return. With a debt pile of £1.5bn and a global workforce of 43,000, the closure of the company was not taken lightly. Many argue that the company had taken on many risky contracts which proved to be unprofitable, such as many delayed hospital projects around the UK. After multiple warnings in 2017, the firm’s lenders were reluctant to give the firm any more cash and it was decided that the firm would be forced into liquidation. [5] Carillion were found to be underestimating the amount of funding needed to reverse the company’s fortunes and did not have any contingency plans for incomplete projects. In this case, it was poor debt management which led to the collapse of such a large and nationally important firm. [6]
In summary, financial distress can come about for a variety of reasons, some of which cannot be avoided. There is a huge number of responses to a firm being distressed, from simply tightening budgets to catastrophic bankruptcy. The closure of Carillion is an excellent example of what not to do, especially if you find yourself in hot water.