Viralnews77 - Financial distress is the stage of declining financial condition that occurs in a company prior to bankruptcy or liquidation (Platt HD and Platt MB 2002). A company can be categorized as experiencing financial distress or financial difficulties if the company shows negative numbers on operating profit, net income and book value of equity and the company merges (Brahmana 2007).
Another phenomenon of financial distress is that companies tend to experience liquidity difficulties as indicated by the company's declining ability to fulfill its obligations to creditors (Hanifah 2013). Below the Journal will discuss further about the company's financial distress that you should know.
Financial distress also occurs when the company fails or is no longer able to meet the debtor's obligations due to lack and insufficient funds to run or continue its business again.
Company Financial Distress
Corporate financial distress is shown as a three-dimensional process consisting of time frame, financial distress, and process stages. The financial distress cycle in the company includes the initial period of declining performance to the lowest point then the recovery phase if the company can improve its performance. When a company experiences financial difficulties, the company is not in the same position but continues to transition to the next stages. If the performance gets worse, then the company will most likely face bankruptcy. However, if the company's performance improves then the company has the opportunity to overcome financial difficulties.
Factors Causing Financial Distress
According to Damodaran (1997), there are several factors that cause financial distress. The following are some of the factors that cause financial distress in the company:
a. Cash flow difficulties
Occurs when the company's revenue from operating activities is not sufficient to cover operating expenses arising from the company's operating activities. In addition, cash flow difficulties can also be caused by management errors when managing the company's cash flow in making payments for company activities that can worsen the company's financial condition.
b. Amount of debt
The policy of taking the company's debt to cover costs arising from the company's operations will create an obligation for the company to repay debt in the future. When the bills are due, while the company does not have enough funds to pay off the bills, the creditor may confiscate the company's assets to cover the lack of payment of the bills.
c. Losses in the company's operational activities for several years
In this case, it is the company's operational loss which can cause negative cash flow in the company. This can happen because the operating expenses are greater than the income received by the company.
Although a company can overcome the three problems above, not necessarily the company can avoid financial distress, that's because there are still external factors of the company that can cause financial distress. According to Damodaran (1997), the company's external factors are more macro in nature, in which the scope is wider. External factors can be in the form of government policies that can increase the business burden borne by the company, for example an increased tax rate can increase the company's burden. In addition, there is still a policy of increasing loan interest rates, which can lead to an increase in the interest expense borne by the company.
The Effect of Financial Distress on Bankruptcy
Smith and Graves (2005) explain that companies that experience two cycles of resisting decline (decline stemming) and cycles of performance improvement (recovery). The trend of the level of financial performance, company size, availability of free assets are factors that need to be considered to predict whether the company is able to survive in conditions of financial difficulty (decline stemming cycle).
Meanwhile, asset reduction, CEO turnover, and employee reduction are strategies that reflect management's efforts (recovery cycle) in overcoming financial difficulties. So that these factors can be used as a basis for consideration in predicting the company's recovery.
Preventing Financial Distress Cause Bankruptcy
Platt and Platt (2002) state that the usefulness of predicting financial distress information in companies is that it can accelerate management actions to prevent problems before bankruptcy occurs.
The management can take merger or takeover action. This means that the company is able to pay its debts and manage the company better. And can provide an early warning sign of bankruptcy in the future. Schuppe (2003) adds that responsive management detects financial distress early. Then act actively to analyze the causes of financial distress and apply the right turnover strategy, will be much more able to control the condition.
Financial distress can be detrimental to the company if it is not immediately recognized. Cooperation between management and company leaders is needed to avoid financial distress in the company.