Causes of Financial Distress among Companies and Individuals

Financial distress describes any situation where a company or a person’s financial condition leaves them struggling to pay bills and basic expenses. When financial distress happens, companies and individuals need to address the situation immediately before it leads to more financial troubles. For instance, their credit rating may drop, causing lenders to charge them higher interest rates and making it difficult to borrow more money to manage a period of reduced income. A company or an individual suffering from serious and prolonged financial distress may eventually resort to bankruptcy to cut losses and possibly reset their financial situation.

Even well-managed companies can experience a period of financial distress, which may be entirely beyond their control. An unexpected economic downturn may result in a significant drop in revenues. For example, the imposed lockdown and quarantine conditions during the COVID-19 pandemic caused many small businesses, which previously enjoyed high or steady income, to lose money or close down.

Companies also suffer from financial distress due to failures by management. For instance, top executives may depend solely on borrowed money to sustain growth. However, if the borrowed money does not eventually lead to increased revenues, the company may struggle to meet debt payments, pay employees, and run its operations. In addition, if a company has borrowed money with adjustable interest rates but has problems paying on time, lenders can impose higher interest rates which substantially decreases its ability to repay the loan.

Companies also experience financial distress due to bad marketing or pricing tactics. For instance, costly advertising campaigns with little or no impact on the sale of the product will hurt the company financially. In addition, if customers reject the product due to poor marketing or prohibitive pricing, the company may also lose business and loyal customers, further weakening its market position.

Poor budgeting and not implementing the right accounting practices can also lead to financial distress, especially for companies with large cash flow problems. Cash flow problems happen when companies underestimate the cost of production, expect profitability too fast, and collect receivables too slowly. Cash flow problems are an excellent indicator of looming financial distress. When a business is constantly spending more than it earns and overhead costs rise, it is more likely that they will drain their cash reserve.

For individuals, financial distress can happen due to lost or reduced income. For example, individuals can get laid off from a job, or the company they work for can go out of business, leaving them suddenly unemployed. If they do not have enough savings or other income streams, they will eventually struggle to pay for housing, utilities, and food. Unexpected expenses, such as a complex medical treatment, can also cause financial distress. Individuals who go through a divorce also suffer from financial strain.

High-income individuals are not immune to stress stemming from money problems. Even individuals who have high-paying jobs can also end up in financial distress due to poorly managing their money. Those who make ill-advised lifestyle choices and investment decisions can see their net worth plummet.