What is Financial Distress & How to Overcome It? – Detailed
Financial Distress: You must have heard a number of times about situations like Financial Distress faced by various organizations. Some organizations couldn’t survive that & that led to their insolvency, while others came up with some other source of finance & somehow managed to survive.
Let us first study about what is Financial Distress; how it leads to insolvency & then let us learn about some sources of financing apart from the traditional modes of Equity & Debt.
Financial Distress & Insolvency
If cash inflows are inadequate, the firm will face difficulties in the payment of interest and repayment of principal. If the situation continues for a long time, there might come a day when the firm would face pressure from creditors for payments.
The firm would find itself in a tight spot. Investors would not invest further. Creditors would recall their loans. Capital market would heavily discount its securities. Thus, the firm would find itself in a situation called distress.
Generally, insolvency occurs subsequent to a period of financial distress. Many a times, if financial distress is identified in time and remedial action is taken, possibility of insolvency can be completely avoided.
Insolvency by contrast, is a decision which the business chooses to take to relieve itself from excess debt burden. It is a decision where the firm decides to sell its assets to discharge its obligations to outsiders at prices below their economic values i.e., resort to distress sale. So when the sale proceeds are inadequate to meet the outside liabilities, the firm is said to have failed or become bankrupt and after due processes of law are gone through, it might turn out to be an insolvent.
Some New Financial Instruments:
Apart from the traditional debt & equity financing, there are other ways too through which the organizations can raise funds. Let us understand a few new & emerging financial instruments.
This instrument covers those cumulative and non-cumulative bonds where interest is payable on maturity or periodically and redemption premium is offered to attract investors.
Dual Convertible Bonds:
A dual convertible bond is convertible into equity shares or fixed interest rate debentures/ preference shares at the option of the lender. The fixed interest rate debenture may have certain additional features including higher rate of interest distinct from the original debt instrument
Deep Discount Bonds:
IDBI and SIDBI had issued this instrument. For a deep discount price of Rs. 2,700/- in IDBI the investor got a bond with the face value of Rs. 1,00,000/-. The bond appreciates to its face value over the maturity period of 25 years. Alternatively, the investor can withdraw from the investment periodically after 5 years. The deep discount bond is considered a safe, solid and liquid instrument.
It is a short term money market instrument. It is kind of an unsecured promissory note. Its maturity period is between 3 – 6 months. It is readily used to arrange funds for a shorter term.
It is a technique in which the financial intermediary bears the credit risk for collection of debts from debts.
It is a technique in which the Forfaitor discounts an export bill & pays ready cash to the exporter. It is similar to discounting of a Bill, except for one condition; here the bill is always an Export Bill.
By resorting to any of the modes mentioned above, funds can be raised by the organizations.