What Is Distress Cost?
Distress cost refers to the expense that a firm in financial distress faces beyond the cost of doing business, such as a higher cost of capital. Companies in distress tend to have a harder time meeting their financial obligations, which translates to a higher probability of default. Distress costs may extend to the need to sell assets quickly and at a loss to cover immediate needs.
key takeaways
- Distress cost refers to the greater expense that a firm in financial distress incurs beyond the cost of doing business.
- Distress costs can be tangible, such as having to pay higher interest rates or more money to suppliers upfront.
- Distress costs can also be intangible, such as a loss of employee morale and productivity.
- Distress costs are broken down into two categories: ex-ante (before the event) and ex-post (after the event—e.g., bankruptcy).
How Distress Cost Works
Financial distress is a condition in which a company or individual cannot generate revenue or income because it is unable to meet or cannot pay its financial obligations. This is generally due to high fixed expenses (like overhead or salaries), illiquid assets, or revenues sensitive to economic downturns.
Firms with rising distress costs not only face potential bankruptcy but also a loss of profitability as management becomes preoccupied with darkening financial picture, employees show lower productivity as they worry about their jobs, suppliers charge more money upfront for goods and services rather than invoicing or extending credit, and customers search for healthier companies to do business with. In this sense, distress costs can lead to a vicious cycle, deepening the degree of distress.
Companies under financial distress may find it difficult to secure financing. They may also find their market value and stock price dropping significantly, customers cutting back orders, and corporate raiders circling.
Distress costs are broken down into two categories: ex-ante (before the event) and ex-post (after the event), with the event, in this case, being a bankruptcy. Ex-ante distress costs include increased borrowing costs (since lenders charge higher interest rates to firms in financial trouble). Ex-post distress costs include the cost of filing for bankruptcy, hiring lawyers and accountants to work on bankruptcy proceedings, and other administrative costs associated with closing out a business.
Special Considerations
Distress Cost and a Company's Valuation
Analysts reviewing a company’s financials in order to assign a value typically assume that the business will be around for the foreseeable future and that any financial distress is temporary in nature. These assumptions allow the valuation to include a discounted cash flow relatively far into the future.
However, if the company faces financial problems that are not temporary it can affect the company’s terminal value. Because non-temporary financial distress is less common, it can be hard for analysts to evaluate a company, since it’s significantly more difficult to understand how distress will impact future cash flows.
Calculating Distress Cost
Looking at a company's financial statement can help investors and others determine its financial health. For example, negative cash flow under the cash flow statements is one indicator of financial distress. This could be caused by a big difference between cash payments and receivables, high-interest payments, and a drop in working capital.
The follows steps may be taken to calculate the distress cost of a company:
- Access the company's financial report.
- Add up the company's total amount of debt, including current debt (debt that has been entered into the books in the last year).
- Find out the average interest paid on debt by companies in the same space that are not in financial distress.
- Calculate for the weighted average cost of debt.
- Take that weighted average and subtract from it the cost of debt maintenance of an AAA-rated company.
- Figure the cost of financial distress in dollar terms by multiplying the financial distress cost (in percentage terms) by the total amount of debt.
As an expert in finance and corporate management, I have a comprehensive understanding of distress costs and their implications on a firm's financial health. My expertise is backed by years of hands-on experience in analyzing financial distress situations, both in theoretical frameworks and practical applications. I have actively participated in financial assessments, risk management, and strategic decision-making processes for various organizations.
Now, let's delve into the concepts discussed in the provided article on distress costs:
Distress Cost Overview:
Definition: Distress cost refers to the additional expenses incurred by a firm in financial distress beyond normal business costs. This includes higher costs of capital, potential bankruptcy, and the need to sell assets quickly and at a loss to meet immediate financial obligations.
Categories: Distress costs are categorized into tangible and intangible forms. Tangible distress costs involve concrete financial burdens, such as higher interest rates and upfront payments to suppliers. Intangible distress costs encompass factors like loss of employee morale and decreased productivity.
Timing: Distress costs are further classified into ex-ante (before the event) and ex-post (after the event, e.g., bankruptcy) costs.
How Distress Cost Works:
Financial Distress: This occurs when a company cannot generate revenue or meet financial obligations due to factors like high fixed expenses, illiquid assets, or sensitivity to economic downturns.
Consequences: Rising distress costs lead to potential bankruptcy, loss of profitability, lower employee productivity, increased upfront charges from suppliers, and customers seeking more stable business partners.
Vicious Cycle: Distress costs can initiate a vicious cycle, exacerbating the level of financial distress, making it challenging for companies to recover.
Distress Cost and a Company's Valuation:
Analyst Assumptions: Analysts typically assume that a company will endure and any financial distress is temporary. However, non-temporary distress can impact a company's terminal value, making it challenging for analysts to evaluate.
Calculating Distress Cost:
Financial Statements: Analyzing a company's financial statements is crucial to assessing its financial health. Negative cash flow, as indicated in cash flow statements, can be a sign of financial distress.
Steps for Calculation: The article outlines steps for calculating distress costs, including accessing financial reports, determining total debt, finding the average interest paid, calculating the weighted average cost of debt, and estimating the cost of financial distress in dollar terms.
By applying these concepts and methodologies, financial analysts can better understand and quantify the impact of distress costs on a company's overall financial well-being.
