THEORIES OF FINANCIAL DISTRESS

AHAM NZENWATA

1.     INTRODUCTION

Financial distress arises when a firm is not able to meet its obligations (payment of interest and principal) to debt-holders. The firm’s continuous failure to make payments to debt-holders can ultimately lead to insolvency. For a given level of operating risk, financial distress exacerbates with higher debt. With higher business risk and higher debt, the probability of financial distress becomes much greater.

The degree of business risk of a firm depends on the degree of operating leverage (i.e., the proportion of fixed costs), general economic conditions, demand and price variations, intensity of competition, extent of diversification and the maturity of the industry.

Companies operating in turbulent business environment and in highly competitive markets are exposed to higher operating risk. The operating risk is further aggravated if the companies are highly capital intensive and have high proportion of fixed costs. Matured companies in relatively stable market conditions have lesser operating risk.

Similarly, diversified companies with unrelated businesses are in better position to face fluctuating market conditions. That is not to say that financial distress is for any market industry segment or type as firms in any industry or market can experience financial distress. More so, those that may outwardly give the impression of being financially healthy.

Financial distress in many cases is caused by a myriad of issues and have consequences that may not have been anticipated. The rest of this paper will address some of the causes and consequences of financial distress.

2.1   REVIEW OF LITERATURE

Five related theory have been cited in previous studies in an effort to understand and explain the phenomenon of financial distress. These are: Coalition behaviour theory, Gamblers ruin theory, Option and credit risk theories, Cash flow theory, and The income finance theory.

Of the five more commonly used theoretical approaches, two directly address the influence of investment decisions on financial distress. These two are coalition behaviour theory (White, 1980) and cash flow theory (Aziz & Lawson, 1989; Gentry et al., 1985a).

However, four of the theories – cash flow theory, gamblers ruin theory, income finance theory, and option theory – take the investment decision into account indirectly through the profitability of the investment.

Cash flow theory by Beaver's (1966) and Taffler (1983) views the firm as ‘a reservoir of liquid assets which is supplied by inflows and drained by outflows’ and states the following four propositions:

·       The larger the reservoir, the smaller the probability of failure;

·       The larger the net liquid-asset flow from operations (i.e. cash flow), the smaller the probability of failure;

·       The larger the amount of debt held, the greater the probability of failure; and

·       The larger the fund expenditures for operations, the greater the probability of failure

Johnson (1970) suggested that economic conditions may have discriminating power in firm failure prediction, and many studies since then have shown that this is indeed so. The study also showed that different accrual-based financial ratios can predict corporate failure, depending on the underlying and expected economic conditions.

Bhattacharjee et al (2009) show that an increase in output per capita lowers the probability of a firm going bankrupt; that uncertainty in the form of sharp increases in inflation and a sharp depreciation of the currency affect newly listed firms adversely; and that higher volatility in inflation levels lowers the probability of firms listed for more than 25 years going bankrupt.

2.2   REASON & CONSEQUENCES OF FINANCIAL DISTRESS

The difficulties that lead to financial distress can be internal risk factor or external risk factors. According to financial theory, internal risk factors usually refer to the internal problems of the company. Therefore, they negatively affect only a particular firm or a small number of firms within the same network. The external risk factors are pervasive; they can affect all companies in the market.

Karels and Plakash (1987) divide all possible causes of financial distress into two groups: internal risk factors and external shocks. Internal risk factors can be attributed to poor management. Potential forms of the appearance of bad management are the absence of a sense of a need for change, inadequate communication, overexpansion, unintentionally improper handling of projects, or fraud.

Exogenous shocks (external risk factors) are independent of managerial skills. They can be classified into inefficiencies in

regulatory development, turbulences in the labor market, or natural disasters. Bibeault (1983) reveals five significant sources of external risk: economic change, competitive change, government constraints, social alterations, and technological change.

Nwogugu (2004) state that the evolutionary development of corporate enterprises as well as a change to more service-oriented economies and an increasing role of governmental regulation provoke a shift from endogenous to exogenous causes of corporate failure. Financial distress occurs as a consequence of management’s failing ability to control and anticipate negative economic effects on the firm’s profitability and future prosperity. In the sample by Nwogugu unanticipated economic shocks cause about 15 to 40% of all distressed situations.

Financial distress may ultimately force a company to insolvency. Direct costs of financial distress include costs of insolvency. The proceedings of insolvency involve cumbersome process. The conflicting interests of creditors and other stakeholders can delay liquidation of the company’s assets. The physical conditions of assets, which are not in use once the insolvency proceedings start, may deteriorate over time (Pandey, 2010). Their realizable values may decline. Finally, these assets may have to be sold at prices, which are much lower than their current values.

Insolvency also causes high legal and administrative costs. The expected costs of insolvency raises the lenders’ required rate of return, which causes a dampening effect on the market value of equity.

Financial distress, with or without insolvency, also has many indirect costs. These costs relate to the actions of employees, managers, customers, suppliers and shareholders. These include the following:

·       Employees of a financially distressed firm may become demoralized:

·       Suppliers also curtail or discontinue granting credit to the firm fearing liquidation and liquidity problems

·       Investors become concerned.

·       Shareholders start behaving differently (in ways detrimental to the firm):

·       Managers generally have a tendency to expropriate the firm’s resources in the form of perquisites and avoid risk.

2.3   STAGES IN FINANCIAL DISTRESS

Financial distress can be broken down into four stages: performance decline, economic failure, technical insolvency, and default. While moving in and out of financial trouble, the company passes through these four separate stages, each of which has specific attributes and, consequently, contributes differently to corporate failure. Financial distress is time-varying which implies that once entering it, the company does not stay in the same state until it is liquidated or until it recovers. The stages or phases of financial distress are as follows:

Deterioration of Performance Stage

The deterioration of performance begins with significant breaches in profitability. A drop in sales, changes in operating income, and negative stock returns are indicators of further decline.In early stages of financial distress operating income falls way below industry average. Flat sales, increasing customer complaints about product quality, delivery, and service as well as late financial and managerial information are signs of the early decline as well. In this stage the company shows significant inefficiencies at the operational level, missing operational goals and related profit margins.

Failure Stage

Failure indicates the movement of the firm from a viable, “tolerable” level of decline to the marginal. Operational decline leads to the cash buffer becoming thin. Cash shortage in consequence of a permanent reduction in cash flow triggers the change in the financial status of the company from solvent to distressed. Given the interaction between deteriorating profitability and insufficient liquidity, the stage of failure is more severe than prior phases of the distress cycle, it cannot be easily overcome, and it can lead to permanent damage and eventually irreparable decline.

Many researchers have analyzed the effect of deterioration in profitability on the competitive position of a distressed company: the market average earnings falls substantially behind that of its rivals and below the market average, the trust of the stakeholders erodes, the employees change jobs, eventually to competitors, and the firm stands in a liquidity squeeze

Insolvency Stage

The most serious problem a company faces at this stage is a lack of cash flows generated from operating activity. Ross et al. (2002) point out two important parts of the insolvency question: stocks and flows. Thinking about insolvency on a stock basis implies that the market value of the company’s assets is less than the face value of its debt, which results in negative economic worth. Flow-based insolvency occurs when the operating cash flows are insufficient to cover current obligations.

In the theory of corporate finance, a cash shortage occurs together with a debt overhang. However, chronologically cash-flow insolvency happens before stock-based insolvency. Since the lack of liquidity in insolvency represents a chronic condition, it means that the decline in cash flows will automatically reduce the fair value of assets and increase leverage.

Default Stage

The occurrence of default symbolizes the peak of the distress development. Default describes an event when the company cannot repay the debt or interest to creditors at maturity and, consequently, violates the conditions of the agreement with the debt-holder, which can be a reason for legal action. A company can be insolvent for a long time. However, only on the date of maturity can it become classified as defaulted on its debt. If the firm faces this event, the negotiation and the private debt restructuring or bankruptcy is the consequence.

3.     CONCLUSION

The purpose of this paper was to explore the theories that try to shed light on the phenomenon of financial distress in order to understand why firms become financially distressed and remedies if any that may be applied to correct the situation. In the course of the research, we explored previous literature on the phenomenon and came to the following conclusions: the causes of financial distress can be either internal or external to the firm. Internal causes include majorly management incompetence while external causes will include unfavourable economic policies and economic instability. We also concluded that there are several stages in financial distress and necessary remedies can be applied at any of the stages. The stages in financial include the following: Deterioration of Performance Stage, Failure Stage, Insolvency Stage and Default Stage. Finally, no matter the stage of financial distress in a firm, appropriate measures can be taken before it deteriorates in bankruptcy.

REFERENCES

Aziz, A., & Lawson, G. H. (1989). Cash flow reporting and financial distress models: Testing of hypotheses. Financial Management, 18, 55–63

Beaver, W. H. (1966). Financial ratios as predictors of failure. Journal of Accounting Research, 4, 71–111

Bhattacharjee, A., Higson, C., Holly, S., & Kattuman, P. (2009). Macro economic instability and business exit: Determinants of failures and acquisitions of large UK firms. Economica, 76, 108–131

Gentry, J. A., Newbold, P., & Whitford, D. T. (1985a). Predicting bankruptcy: If cash flow's not the bottom line, what is? Financial Analysts Journal

Johnson, C. G. (1970). Ratio analysis and the prediction of firm failure. Journal of Finance, 25, 1166–1168.

Pandey, I. M. (2010) Financial Management, 10th Edition, Vikas Publishing House Pvt Ltd, India

Taffler, R. (1983). The assessment of company solvency and performance using a statistical model. Accounting & Business Research, 13(52)

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