Investing to Wealth

Financial distress is a term that indicates a condition when promises to creditors of a company are broken or honored with difficulty.

Financial distress typically leads 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 firms 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 firms value to rise over debt. Risky projects are not in the interest of creditors however 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 bancruptcy, 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.

In a more general sense, financial distress is a reduction in financial efficiency that results from a shortage of cash. This concept applies even to individuals and households. Imagine that you have no preference about what kind of toilet paper you use, so you simply buy the cheapest toilet paper available. This means you go to a big box store every few months and buy in bulk. But to take advantage of the lowest price, you have to buy a large quantity and spend several dollars. Now imagine that you were short on cash as your toilet paper was running low. You cannot afford to buy in bulk, so you buy a small package at a convenience store. In order to minimize your total cash outlay, you accept a higher unit cost. That’s what happens in financial distress.

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