Session 4: Indicators and Souces of Financial Distress

Learning Objectives
At the end of this session, students should be able to:

• Determine the costs of financial distress
• Explain the factors influencing the risk of financial distress

Important Learning Terms

• Financial distress
• Costs of financial distress
• Indicators for financial distress

In the real world companies do not, generally raise their debt-to-equity ratios to very high levels. This suggests that there are other important influences on capital structure besides lower costs of debt and tax relief on debt. The basic additional factors which have a bearing on the gearing level are: financial distress (bankruptcy costs); agency costs; borrowing capacity; managerial preference; pecking order; financial slack; signalling; control; and industry group gearing.

Financial Distress
Financial distress is defined as a condition where obligations are not met or are met with difficulty.
A major disadvantage for a firm taking on higher levels of debt is that it increases the risk of financial distress, and ultimately liquidation. This may have detrimental effect on both the equity and debt holders.

Effects of Financial Distress

• The risk of incurring the costs of financial distress has a negative effect on a firm's value which offsets the value of tax relief of increasing debt levels.
• These costs become considerable with very high gearing. Even if a firm manages to avoid liquidation its relationships with suppliers, customers, employees and creditors may be seriously damaged.
• Suppliers providing goods and services on credit are likely to reduce the generosity of their terms, or even stop supplying altogether, if they believe that there is an increased chance of the firm not being in existence in a few months' time.
• Customers may develop close relationships with their suppliers, and plan their own production on the assumption of a continuance of that relationship. If there is any doubt about the longevity of a firm it will not be able to secure high-quality contracts. In the consumer markets customers often need assurance that firms are sufficiently stable to deliver on promises.

In a financial distress situation, employees may become demotivated as they sense increased job insecurity and few prospects for advancement. The best staff will start to move to posts in safer companies.

Bankers and other lenders will tend to look upon a request for further finance from a financially distressed company with a prejudiced eye – taking a safety-first approach – and this can continue for many years after the crisis has passed.

Management find that much of their time is spent "fire fighting" – dealing with day-to-day liquidity problems – and focusing on short-term cash flow rather than long-term shareholder wealth.

The indirect costs associated with financial distress can be much more significant than the more obvious direct costs such as paying for lawyers, accountants and for refinancing programs. Some of these indirect and direct costs are shown in the table below:

Some Indicators of Financial Distress
As the risk of financial distress rises with the gearing ratio shareholders (and lenders) demand an increasing return in compensation.

The important issue is at what point does the probability of financial distress so increase the cost of equity and debt that it outweighs the benefit of the tax relief on debt?

Financial Analysis may be used to view some of the indicators of the financial distress. Important ratios to be considered include:

• Liquidity ratios
• Debt management ratios
• Asset utilization ratios

The ratios provide indicators on whether the firm is facing financial problems in meeting both its current and long term debt obligations. Other indicators are as discussed below.

Some Factors Influencing the Risk of Financial Distress Costs
The susceptibility to financial distress varies from company to company. Here are some influences:

1. The sensitivity of the company's revenues to the general level of economic activity.
   If a company is highly responsive to the ups and downs in the economy, shareholders and lenders may perceive a greater risk of liquidation and/or distress and demand a higher return in compensation for gearing compared with that demanded for a firm which is less sensitive to economic events.
2. The proportion of fixed to variable costs.
   A firm which is highly operationally geared, and which also takes on high borrowing, may find that equity and debt holders demand a high return for the increased risk
3. The liquidity and marketability of the firm's assets.
   Some firms invest in a type of asset which can be easily sold at a reasonably high and certain value should they go into liquidation. This is of benefit to the financial security holders and so they may not demand such a high-risk premium.
4. The cash-generative ability of the business.
   Some firms produce a high regular flow of cash and so can reasonably accept a higher gearing level than a firm with lumpy and delayed cash inflows.

Discussion 6
Post your response in the discussions area. (See the procedure for discussions in Course Info.)
Discuss whether there is any rationale to study the financial distress of telecommunication companies:

1. Explain what are the possible costs for the ICT industry given the financial distress situation?
2. What action will the regulators take if in the market where the firm(s) encountered financial distress? Express your answer based on two nature of economies (monopoly and competitive market)
3. You are given a set of financial statements including the balance sheet and the income statement of S.O.SONEY for the three consecutive years. All data is in million shillings.