Financing through debt is cheaper than through equity. This means more debt lowers the total cost of capital of a company, increasing its value.
On top of that, increasing debt reduces the amount of corporate taxes a company has to pay the government. This is an incentive to more debt.
Why don’t businesses use more debt?
Risk of financial distress.
Along with agency costs and asymmetric information, financial distress costs are imperfections that can alter capital structure decisions.
In this article, we’ll go through 4 early indicators of financial distress. First, let’s understand the definition of financial distress:
What is Financial Distress?
A company is in financial distress when it has trouble meeting its debt obligations.
Costs of financial distress can offset the tax benefits of leverage when leverage is high. This means there’s a tradeoff:
Companies must weigh the benefits of tax shields from debt against the costs of distress.
Debt financing puts an obligation on the company—to pay lenders interest. A company that fails to make the required interest or principal payments on its debt is in default.
After the firm defaults, debt holders get rights to the assets of the business. In an extreme case, debt holders take legal ownership of those assets through a process called bankruptcy.
Equity financing does not carry this risk. Although equity holders hope to receive dividends, the company is not legally obligated to pay them. Meanwhile, it is obligated to pay interest to debt holders.
Now, there are two types of distress. Financial distress is different from economic distress.
Economic distress is when the company declares bankruptcy (and has a negative debt-to-equity ratio). Financial distress is when the company defaults on its interest payments.
There are many warning signs a company is in distress, and you can find most in its financial statements.
What are four signs that a business might be in financial distress?
#1) Lack of Cash
The main sign of trouble is a lack of cash. This is the most important of the indicators of financial distress and business failure.
An increase in income is good. However, this does not mean more money is entering the company. Most businesses give their clients a certain number of days (trade credit), months, or even years to materialize a deal into an actual cash flow.
This means a business may have negative cash flows despite growing revenue. How? Because it fails to collect its receivables on time.
Growing receivables on the balance sheet could be an early sign of financial distress. The business will eventually lack the cash needed to keep its operations going.
This is especially risky when the company has just one or two major customers.
Just like sales, costs also don’t mean a cash flow exited the company. Suppliers give you time to pay for the goods and services needed to run your business.
However, interest payments don’t work like this. Every dollar on the profit and loss under this category is actual cash leaving the company.
This is why a lack of cash may indicate too much debt, as interest payments are eating up all the money available. The debt is likely being used for new projects.
The earnings from the new projects will help pay off the debt and interest that funded it and bring in more profit for the company. The problem is when those earnings take too long to be converted into cash.
Sudden changes in these numbers must be analyzed to see whether they are signs of something more serious.
A cut in dividend payments may also indicate the company needs to save money to face financial distress.
#2) High Interest Payments
Banks and other lenders evaluate the creditworthiness of a business on a regular basis. They’re constantly looking for signs a company is in financial trouble.
Increasing debt will make the bank suspicious of your financial health. In this case, your business is considered riskier to lend to.
As a result, the bank will want to be compensated for the extra risk, and they’ll do so by increasing the interest rate they charge on the loans they give you. Funding debt will cost you more. They’ll also request more collateral.
This has a snowball effect. The business already has a lot of debt and is now paying more interest on that debt. Sooner or later, the pressure on cash flows will be too much and the firm will start missing payments to suppliers and creditors, damaging those relationships.
#3) Poor Growth
Poor profits are another indicator of financial distress, as it may point to a financially unhealthy business.
With the expenses on interest going up, lower margins and poor growth follow suit.
This happens because the money the firm used to invest in growing the business—new equipment, more human capital, and better facilities—is now going towards paying off the interest on the debt.
To add to the problem, employees who can sense something is wrong will be unhappy. When they’re in leading positions they may pass it on to their team, and start deploying sudden strategies to cut costs.
A business where the costs are too high compared to revenue is not sustainable long term.
#4) Growing Competitors
There are several reasons that can explain a business in distress losing market share.
Low revenue growth indicates the demand for the company’s goods or services declined. The demand is going elsewhere.
Clients start buying from competitors if the quality of their products is better, or they have better customer service, or better marketing. Guess what? The distressed business will make cuts that affect the quality of its product, service, and marketing. All because of too much leverage.
Unless the distressed business changes its existing business model in some way, it will be forced to close its doors.
Firms in unstable industries (for example tech, and airlines) need to be extra careful using too much debt. Their future cash flows are unstable and highly sensitive to shocks in the economy, which means they run the risk of bankruptcy if they use too much leverage.
The Bottom Line
There you have it! Now you know what are the indicators of financial distress.
A business is in financial distress when it has trouble paying the interest payments on its excessive debt.
The debt was likely used in new projects that are growing the firm’s revenue, but is that revenue actual cash or just promises?
Lack of cash will make it difficult to keep up with interest payments, as they can’t be postponed.
Banks notice immediately when a business is in excessive debt. As result, they want to be compensated with a higher interest rate for the additional risk of default. Companies in financial distress will be charged even more interest, to add fuel to the fire.
With all the money going towards interest payments, it becomes difficult to grow the company, especially in industries where future cash flows are unstable.
Questions? Feedback? Opinions? Leave them in the comments below!
