How bad capital structure can create financial distress

Financial distress is a situation in which an organization will be unable to repay its financial obligations due to high cost, lack of liquid assets or economic downturn. In this article, we will discuss how bad capital structure can create financial distress for a company or organization.

Economists have put 4M as the most essential resources of a successful business; men, materials, machines and money. Among these, money or finance is considered as the lifeblood of many organized business as it paves ways for the other resources to come into play. Quality of money depends on proper mix of the capital structure such as debt, equity and different classes of long term funds.

If you have enough money, other resources like men, material and machines could be employed to create wealth as use of these resources have a distinct cost. Money for a company can be arranged and managed with proper mix in order to maximize company’s net profit.

Impact of debt on capital structure

Debt is a costly source of capital for the company. However, not resorting to debt means that the business pays more taxes. High debt is a problem in an economic downturn if profit not able to service them.

If a company has debt in the capital structure, business success depends on the following factors:-

  • ability of the company to meet its debt obligations in time,
  • ability to make timely payments to all the stakeholders of the business such as suppliers, employees, government agencies and others.
  • ensure fair rate of returns to the owners or shareholders.

All these factors can be achieved only when the business has sufficient capital and generating enough profit.

To understand the relationship of capital structure and financial distress, we have to know the impact of debt finance on profitability.

If more debt is used in a capital structure, fixed legal obligations towards payment of interest and principal increases due to which with the same profitability, company’s ability to satisfy these demand decreases. Therefore, if more debt finance is used in capital structure and company’s profitability reduces, then it may lead to financial distress and bankruptcy.

Decrease in operating earnings has a greater risk of not satisfying the debt obligations and hence increase the probability of financial distress.

Here are few factors that influence the chances of financial distress:

  • Probability of financial distress increases with the increase in business risk and financial risk.
  • When debt to equity ratio increased
  • Operating profit of the company comes down drastically due to economic downturn.

How finance manager can manage financial distress

It’s the job of the finance manager to carefully decide the proportion of finance mix. In this regard, the finance manager must decide on following things in order to avoid financial distress;

  • How much should be kept in the form of equity.
  • How much debt to be considered in capital structure. From which bank or financial institutions it must be funded and what will be its cost to the company.
  • The amount of current liabilities and assets on the balance sheet.
  • How the working capital requirements needs to be met.
  • How balance between risk and return is to be managed.