Question

Suppose managers of a firm know that the company is approaching financial distress. Should the managers borrow from creditors and issue a large one-time dividend to shareholders? How might creditors control this potential transfer of wealth?

Answer 1

Financial distress- It is a condition when company is unable to generate revenues and profits and unable to pay dividends to shareholders. Company is also unable to repay its obligations. This may be due to following reasons:

1. Higher cost
2. Illiquid assets
3. Economic downturns
4. Customers cancel the orders
5. Sales come down due to lower demand and competition.

No managers should not borrow from creditors because company is already in debt and unable to pay its obligation and interest. It should not take more loans just to please the shareholders. In long run, debt is not good. Shareholders can be assured that they will get dividend once company starts generating profits. More loans may lead to bankruptcy situation.

What to do in financial distress condition- There are some strategies to overcome financial distress:

1. Company should find out its weak points and loopholes because of which it is facing financial distress.
2. It should concentrate on its product/service and try to modify it so that it can be more salable.
3. Company should maintain the trust of customers as well as shareholders.
4. If a company is private, it can go public with the help of Initial public offering and can raise money to reduce the financial crisis.
5. Company should timely pay the interest to creditors.
6. Managers and employees all should work harder to take the company out from the financial distress.