What Causes Financial Distress? (Top 6 Reasons You Should Know)

The term “financial distress” is a common experience many individuals and organizations have gone through. When an individual is going through financial distress, the person cannot generate enough income to cover their expenditure.

Financial distress occurs in an organization when the company cannot generate revenue that is sufficient to cater to all financial obligations. There are so many factors that may trigger financial distress in an organization. Notable among these factors are a fixed cost that is unusually high and a constant downturn in the economy.

Unfortunately, many individuals and organizations ignore the red flags until it gets out of hand. It is possible to remedy financial distress with early detection. However, an organization has to take decisive steps to nip it at the bud. Leaving financial distress unchecked is courting bankruptcy.

Understanding Financial Distress

A proper understanding of what it means to go through financial distress is very vital. Some organizations go through financial distress without identifying it for what it is. Whenever a business finds it difficult to meet up its financial obligations, it is most likely going through a period of distress.

In terms of productivity, a company going through financial distress is more likely to be less productive. The employees of such companies are also under a higher measure of stress and uncertainty. This uncertainty is the fear that the company would go into bankruptcy, leading to winding down.

The supply for the company’s product may fall considerably during this period. The reason is that the company may not have enough funds to purchase materials needed to continue production. Investors may also pull out from the company during financial distress as its market value continues to plummet.

Reasons for financial distress

So many factors may contribute to financial distress in an organization. Some of the most likely causes of financial distress include:

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#1. Management challenges

The person behind decision-making determines the direction a company is headed at each point in time. In a situation where the manager is narrow-minded and preoccupied with day to day running of the business, changes in the external environment will take the company by surprise.

A manager with foresight will try at each point to determine what the future could hold for the organization. With this information, the organization will be better placed to plan and prepare for future occurrences strategically. Businesses that did not prepare ahead for contingency will most likely suffer distress during the global pandemic.

#2. Poor budget preparation and execution

One factor contributing to financial distress in organizations is the inability to develop good budgets and stick to them. It is ideal to look at different budgeting patterns and go for the one that produces the best results.

Also, beyond having a good budget, execution is a necessity. Without sticking to the provisions of the budget, you won’t be able to achieve much. A necessary part of the budget of an organization is ‘reserve”.

If the company makes no provision for reserve in the process of budget preparation all through the years, the company will have nothing to rely on during periods of shortfalls. A continuous deficit budget is always an indication that the organization is heading towards deep financial problems.

#3. Inaccurate assumptions

While preparing an organization’s budgets, the person in charge uses some measure of assumption to arrive at projected income and expenditure. These assumptions may be avenues for incredulous employees to make away with the company’s funds without detection.

#4. Poor debt management

Debt is a normal part of every business. That a business owes does not sentence such business to distress. What, however, makes the difference is the management of business debts. When a business has a poor debt management program, it may result in lots of financial problems. These financial problems will, in turn, result in a negative impact on the company’s budget.

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#5. Poor decision making

Organizations should make decisions after considering and analyzing several key factors. A proper analysis is not done in light of the company’s objectives and goals. Financial distress becomes inevitable.

#6. A dearth of innovation

The business world is a dynamic one that is susceptible to changes. The changes that are seen in businesses also have great financial implications. Organizations are more likely to go through financial distress if there are no innovative ways of dealing with changes. It is therefore important that management find innovative ways of responding to these changes.

Indicators of financial distress

Like so many other things, financial distress has telltale signs that help organizations decipher that it is going through ups and downs. Some of the signs of financial distress that organizations should look out for includes:

  • Poor profits: when an organization experiences a visible decline in its profit margin, it could be an indication that it is going through financial distress. When a business struggles to break even, it is an indication that the business is having difficulties generating enough revenue to take care of the running of the business. What most businesses do at this point is to look for ways to raise funds externally. However, getting loans from other sources reduces the creditworthiness of a business.
  • A decline in sales: a visible decline in sales is an indication that the demand for the product of a business is no longer sufficient for the customers. If after doing all there is to be done, and the organization discovers that sales remain pegged at a point, it may be an indication of impending financial distress.
  • Increase in bad debt: businesses may carry out their transactions and give out their products or services on credit. However, when there is an increase in the number of debtors who are not willing to pay up on time, that could be a red flag.
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How can a business remedy financial distress?

Financial distress may seem like an impossible situation to come out from, yet, it is possible to turn things around and remedy the situation. What should an organization do if it finds itself in financial distress?

  • Review business plan: a business plan details the strategy a business intends to apply in the penetration of the market. A business plan has a direct and indirect effect on the operations and finances of a business. Financial distress could be evidence that the company needs to go back to the drawing board and re-strategize on how best to go about their business. In reviewing the business plans, the company’s leadership comes up with specific goals and targets to be made.
  • Find areas to cut costs: financial distress signifies that a business is spending more than it earns. In that situation, the management may need to look into the operations of the business and discover how best to cut down costs. The areas to consider cutting down costs may include staff payment or management incentives.
  • Debt restructuring: debt is not a strange occurrence in business. However, not managing debt repayment and restructuring appropriately may affect the financial position of the business. A business going through financial distress could negotiate a better debt repayment plan to make repayment more manageable

Conclusion

A business going through financial distress can manage the situation by looking for ways to cut back on operational expenses and increasing its income.

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