Definition and Cycle of the Financial Distress
Wruck (1990) defines financial distress as a situation where cash flows are insufficient to cover current obligations. These obligations may include payables, expenses of litigation or interest payments.
According to Baldwin and Scott (1983), when the situation of a company deteriorates to the point where it can not meet its financial constraints, the company enters into a state of financial distress. These same authors assert that this is the result of a poor economy, a decline in their performance and low quality of their managements. Modigliani and Miller (1959) showed that only efficient firms, effective and efficient, are ready to support a relatively large debt because they are able to meet their obligations without problems. Jensen (1986) argues that debt acts as a disciplinary mechanism on the leaders and has a positive impact on business performance. According to Finet (2001), the granting of debt results from the difficulties experienced by the company. It becomes part of the weakening of its operating performance, its capital as well as its reputation. Opter and Titman (1994) argue that the debt is a factor of financial distress that may endanger the survival of the company. John (1993) considers that the financial distress results from poor synchronization between the cash availability and contractual obligations during a given period. In other words, it is the inability/impossibility to meet the current liabilities with the available assets. The risk of insolvency as well as the breach of any contractual clauses are signal of financial distress (Chou et al., 2010).Confusion arises when the term “insolvency” is used as a synonym for “financial distress.” Insolvency can be interpreted as relating to the assets or cash, but the two are often confused. For example, Webster’s New World Dictionary defines insolvency as first, unable to pay all debts and then, as the inability to pay debts that are due.
The structural insolvency, or asset base, occurs when the value of a company’s assets is less than the value of its debts implying negative equity.Operational insolvency, or base flow, occurs when the company has inadequate cash flow to cover contractually required payments.
Flow-based insolvency gives creditors the right to require the restructuring because their contract with the company was not respected.
In such a situation, creditors are not supported by shareholders since their rights to equity are still preserved. When the value of a firm increases dramatically, shareholders reap the benefits.
According to Franks and Sussman (2005), a firm is defined as being in distress when its local bank branch or regional credit manager decides to transfer a status report to the monitoring unit of economic firms or to the person in charge of financial diagnosis. Such decisions may be triggered, especially for SMEs, in the case of violations of some terms (non payment of interest, exceeding the overdraft limit,...), or due to improper assessment of the future of the firm by credit managers (by reference to indicators such as high debt and low profitability...).
Bankruptcy and liquidation are also used as synonyms for the financial distress. Wruck (1990), considers bankruptcy as the legally adopted process to cancel and rewrite contracts. Liquidation refers it to the sale of assets of the firm and the distribution of income to the beneficiary or beneficiaries.