Question

Why is financial distress important in business firms? What is the difference between bankruptcy and liquidation?

Answer 1

A business firm is said to be in a financial distress when it is not financially viable to continue its operations due to one or more of the following reasons:

1. it is not able to pay its creditors on time,
2. it does not realise its debtors on time thus affecting cash flows,
3. it incurs high fixed costs,
4. it does not have adequate internal sources of funds to fund its operations,
5. it borrows funds at a high interest rate leading to decrease in profits,
6. the sales are poor leading to decrease in revenue,
7. It is not able to break-even.

The above list is not exhaustive. There could be several other factors that could lead to a business firm in financial distress depending upon the nature, environment and industry in which the business operates.

Prolonged periods of financial distress usually serves as a precursor to liquidation. Hence, early recognition of financial distress is important for a business firm as it gives the business a chance to take corrective measures and avoid the unwanted prospect of liquidation. A period of Financial distress requires a business firm to assess the depth of inefficiencies in its operations. A business firm may also have to restructure itself financially, operationally and technically in order to achieve its target returns. A business firm may also consider hiring an expert who can assess the level of financial distress accurately and chart out a plan of resurrection.

Difference between Bankruptcy and Insolvency:

The terms Bankruptcy and Insolvency, though often used interchangeably, are two situations that have a considerable number of difference that demand a proper usage.

Bankruptcy: When an Individual or a Company is unable to pay its debts it is said to be bankrupt. Such bankruptcy may be declared voluntarily by the individual or the company. When a court order is passed declaring the Individual or entity insolvent, it is known as Involuntary Bankruptcy. Once an Individual is declared as bankrupt he then pays off his debts with the help of the government.

Liquidation: Liquidation is the event that follows the winding up process of an entity. After an entity is wound up i.e., it has closed its operations, the process of liquidating its assets to relinquish its debts and liabilities starts. Usually a company goes in to liquidation when it is unable to continue its business profitably. Having said that, it may so happen that an entity may choose to liquidate itself although it is making profits, when it has fulfilled or achieved the limited objectives for which it was started.