Effects of Financial Distress
Financial statements are historical records of a company’s position at some point in the past. By the time financial statements are made public, changes in various economic areas such as market conditions, currency exchange rates, and inflation can change the values of assets and liabilities. In particular, there are often discrepancies between book vales of the assets and liabilities and their value in the market. When this happens, wise investors are quickly able to revalue the firm to reflect a more accurate view of a company’s profitability.
In previous articles on the valuation of assets, there was an assumption that the company was enjoying profitable times, the company was healthy. However, not all companies are healthy; many go through periods of financial distress. In particular is the threat of not being able to cover debt obligations. The first sign of financial distress is usually indicated when a firm does not have enough liquid assets (short-term assets) to cover (pay for) current liabilities (short-term liabilities). When this happens, the likelihood of covering long-term liabilities is reduced resulting in creditors taking on more risk than the investment of loaning money to the firm is worth.
When a company is facing financial distress, book values of the company’s liabilities can become worth more than the market values of the same liabilities. When this happens, the firm is in danger of not meeting its contractual obligations to creditors increasing the likelihood that creditors will not be paid. In the worst of financially distressed times, the creditors may receive nothing in interest or principal if the firm files for bankruptcy and creditors can not longer claim the liabilities as assets.
In distressed times, book values of long-term debts almost always are worth more than market values. The time to maturity of long-term liabilities also affects market values. Just naturally, longer maturities increase the risk of a loan because company’s have a longer time in which to default on a loan. Short-term loans are far less risky than long-term loans because of the Time Value of Money Principle. Financial distress only adds to the riskiness of long-term debt forcing discrepancies between book and market values.
Investors who own stocks in financially-distressed firms are under great risk of losing the investment. This is because contractual obligations such as debts must be paid first before dividends to stockholders. When a company is having trouble paying its contractual obligations, the likelihood of realizing the value of dividends is diminished. Financial distress also signals to the market that the company is no longer profitable and investors will usually begin to sell shares of the company to mitigate losses. The selling of large volumes of a company’s stock reduces the price of the stock, further compounding the losses to owners. The Theory of Efficient Markets suggests that all information about a company is accurately portrayed in its stock price quickly and efficiently. By the time the news about a financially distressed company hits the market, market efficiency has already adjusted the price to reflect the information.