When a company is in financial distress it hires outside professionals, such as tax and accounting experts with experience selling distressed assets. Investment bankers may also assist with financial restructuring.
These are direct costs of financial distress.
Aside from the direct legal and administrative costs of financial distress, there are many other indirect costs (whether the company has formally filed for bankruptcy or not).
Even though these costs are difficult to measure accurately, they are often larger than the direct costs of financial distress and bankruptcy.
In this post, we’ll go over what are some examples of indirect financial distress costs:
#1) Loss of Customers
Bankruptcy may encourage the company to neglect previous deals made with its customers. Because of this, customers will think twice before buying products whose value depends on future support or service from the company.
Here are a few examples of these types of products:
- Plane tickets from a distressed airline that may shut down operations soon.
- Cars from a distressed manufacturer that may fail to honor its warranties or deliver replacement parts.
- Customers of tech companies don’t want hardware or software that will not be supported or upgraded in the future.
In contrast, the loss of customers is likely to be small for producers of raw materials (such as sugar or steel). Why? Because once these goods are delivered, their value doesn’t depend on the seller’s continued success.
#2) Loss of Suppliers
Customers are not the only ones who move away from a business in financial distress.
Suppliers don’t want to provide inventory to a business if they fear the business won’t pay them.
This type of disruption is an important financial distress cost for firms that rely heavily on trade credit.
For example, an airline will shut down if its suppliers refuse to fuel its planes.
#3) Loss of Employees
Companies in distress cannot offer job security with long-term employment contracts. As result, they have trouble hiring new talent, and existing employees may quit or be hired away.
Retaining key employees may be costly, further draining the companies’ cash.
This type of indirect financial distress cost is higher in businesses whose most value comes from their human resources.
#4) Loss of Receivables
Firms in financial distress have difficulty collecting money owed to them.
Here’s why:
For big corporations, customers with smaller amounts of trade debt will try to hide, in the sense that they believe the distressed business won’t bother pursuing them because the amount they owe is small.
Knowing the firm is going out of business reduces the incentive for customers to maintain a reputation for timely payment.
#5) Fire Sales of Assets
In an effort to avoid bankruptcy and its associated costs, companies in distress may attempt to sell assets quickly to raise cash. As a result, they will accept a lower price than what is optimal if they were financially healthy.
The costs of selling assets below their fair value are bigger for companies with assets that lack liquid markets.
Companies in bankruptcy may also need to liquidate assets that are more valuable if kept. For example, a distressed company holding forward positions with the intent of hedging the risk of variations in the prices of its supplies may be forced to close those derivative contracts with their counterparties, in many cases at unattractive terms.
#6) Costs to Creditors
The bankruptcy of a huge corporation will put its creditors in a tough spot, because that corporation is likely their biggest client.
If the loan to the distressed firm was a significant asset for the creditor, default of the firm may lead to financial distress for the creditor.
The costs of going through bankruptcy will not exceed the cost of renegotiating with the company’s creditors. Why? Because they have a say in the bankruptcy process. It is a choice the firm’s investors and creditors make, together.
The Bottom Line
It is difficult to estimate the indirect financial distress costs that arise from the firm’s customers, suppliers, or employees. In total, they can be substantial.
Many of these costs appear prior to bankruptcy, in anticipation of the fact that the firm will use bankruptcy to renegotiate its contracts and commitments.
Customers fear the company uses bankruptcy to stop honoring warranties on its products.
Suppliers fear they’ll back out of delivery contracts for goods and services.
And employees fear the company uses bankruptcy as an excuse to abandon promises of future employment or retirement benefits.
Because of this fear that the firm will not honor its long term commitments in bankruptcy, highly levered firms need to charge less for their products, pay higher prices to their suppliers, and pay more to their employees than similar firms with less leverage.
On top of that, there’s the cost of renegotiating debt to avoid bankruptcy.
This is why indirect financial distress costs can be substantially greater than other kinds of bankruptcy costs.
