# Financial Distress: Definition, Signs, and Remedies

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*Defaulting on a debt can hurt your credit score and may also result in certain assets being seized. — Investopedia / Madelyn Goodnight*

> **Definition**
>
> Financial distress refers to a state wherein a business or person lack sufficient funds to cover all of their financial obligations. Remedying this condition may require drastic measures, such as layoffs or cutting discretionary expenses.

### What Is Financial Distress?

Financial distress is a condition in which a company or individual cannot generate sufficient revenues or income, making them unable to meet or pay their financial obligations. This is generally due to high fixed costs, a large degree of illiquid assets, or revenues sensitive to economic downturns. For individuals, financial distress can arise from poor budgeting, overspending, too high of a debt load, lawsuit, or loss of employment.

Ignoring the signs of financial distress before it gets out of control can have devastating consequences. There may come a time when severe financial distress can no longer be remedied because the company or individual's obligations have grown too high and cannot be repaid. If this happens, bankruptcy may be the only option.

### Key Takeaways

*   Financial distress happens when revenues or income no longer meet or pay for the financial obligations of an individual or organization.
*   Financial distress is often a harbinger of bankruptcy and can cause lasting damage to one's creditworthiness.
*   In order to remedy the situation, a company or individual may consider options such as [restructuring debt](https://www.investopedia.com/the-best-debt-relief-companies-8763179) or cutting back on costs.

## How Financial Distress Works

If a company or individual experiences a period of time when they cannot pay their debts, bills, and other obligations by their due date, they're likely experiencing financial distress.

Examples of a firm's expenses that must be paid may include paying interest on debts, [opportunity costs](https://www.investopedia.com/terms/o/opportunitycost.asp) of projects, and employees who aren't productive. Employees of a distressed firm usually have lower morale and higher stress caused by the increased risk of [bankruptcy](https://www.investopedia.com/terms/b/bankruptcy.asp), given it would likely result in the loss of their jobs. Companies under financial distress may find it difficult to secure new [financing](https://www.investopedia.com/terms/f/financing.asp). They may also find the market value of the firm falls significantly as customers cut back on new orders and suppliers change their terms of delivery.

Looking at a company's [financial statements](https://www.investopedia.com/terms/f/financial-statements.asp) can help investors and others determine its current and future financial health. For example, [negative cash flows](https://www.investopedia.com/ask/answers/050415/how-should-i-evaluate-company-negative-cash-flow-investing-activities.asp) appearing in the company's cash flow statement is one red flag of financial distress. This could be caused by a large disparity between cash payments and receivables, high interest payments, or a [drop in working capital](https://www.investopedia.com/ask/answers/100915/can-working-capital-be-negative.asp).

[Individuals who experience financial distress](https://www.investopedia.com/spot-the-signs-of-financial-abuse-11745056) may find themselves in a situation where their debt servicing costs are greater than their monthly income. These debts or obligations may include mortgage or rent payments, auto loan payments, credit cards, and utility bills. People who experience financial distress tend to go through it for an extended period of time and ultimately may be forced to relinquish assets secured by their debts or face eviction, where applicable.

> **Important**
>
> Individuals who experience financial distress may be subject to wage garnishments, judgments, or legal action from creditors.

## Signs of Financial Distress

There are multiple warning signs that could indicate a company is experiencing financial distress or is about to in the near-term. Poor profits may point to a company that's financially unhealthy. Struggling to break even suggests a business cannot sustain itself by generating internal funds and must instead raise capital externally. This increases the company’s [business risk](https://www.investopedia.com/terms/b/businessrisk.asp) and lowers its creditworthiness with lenders, suppliers, investors, and banks. Limiting access to funds typically results in a business (or individual) failing.

Declining sales or poor sales growth indicates that demand isn't there for a company’s products and/or services based on its existing business model. When expensive marketing campaigns result in no growth, consumers may no longer be satisfied with the company's offerings and it may be forced to close down. Likewise, if a company offers poor quality products or services, consumers may start buying from competitors, eventually forcing a business to close its doors as well.

When debtors take too much time paying their debts, [cash flow](https://www.investopedia.com/terms/c/cashflow.asp) may be severely stretched. The business or individual may be [unable to pay its own liabilities](https://www.investopedia.com/terms/a/asset-deficiency.asp). This risk is especially enhanced when a company has just one or two major customers.

## How to Remedy Financial Distress

As difficult as it may seem, there are ways to turn things around and remedy financial distress. One of the first things many companies do is to review their business plans. This should include both their operations and performance in the market, in addition to setting up a target date to accomplish all of their goals.

Another consideration is where to cut costs. This may include laying off staff or even cutting back on management incentives, which can often be costly to a business' bottom line.

Some companies may consider restructuring their debts. Under this process, companies that cannot meet their obligations can renegotiate their debts and change their repayment terms in order to improve their liquidity. By restructuring, they can continue operations.

For individuals who experience financial distress, the tips to remedy the situation are similar to those listed above. Those affected may find it prudent to cut back on unnecessary or excessive spending habits, such as dining out, travel, and other purchases that may be deemed a luxury. Another option may be [credit counseling](https://www.investopedia.com/terms/c/credit-counseling.asp). With credit counseling, a counselor renegotiates a debtor's obligations, allowing them to avoid bankruptcy. [Debt consolidation](https://www.investopedia.com/terms/d/debtconsolidation.asp) is another method for reducing monthly debt obligations by rolling high-interest debts into a single, lower-interest personal loan.

## Distress in Large Financial Institutions

One factor contributing to the [financial crisis of 2007–2008](https://www.investopedia.com/terms/s/subprime-meltdown.asp) was the government’s history of providing emergency loans to distressed financial institutions in markets believed "[too big to fail](https://www.investopedia.com/terms/t/too-big-to-fail.asp)." This created an expectation for parts of the financial sector being protected against losses, known as [moral hazard](https://www.investopedia.com/terms/m/moralhazard.asp).

The federal financial safety net is supposed to protect large financial institutions and their creditors from failure to reduce systemic risk to the financial system. However, these guarantees also encouraged imprudent risk-taking that caused instability in the very system the safety net was supposed to protect.

Because the government safety net subsidizes risk-taking, investors who feel protected by the government may be less likely to demand higher yields as compensation for assuming greater risks. Likewise, creditors may feel less urgency for monitoring firms implicitly protected. Excessive risk-taking means firms are more likely to experience distress and may require bailouts to stay solvent. Additional bailouts may erode market discipline further.

Resolution plans or corporate "living wills" may be an important method of establishing credibility against bailouts. The government safety net may then be a less attractive option in times of financial distress.

## The Bottom Line

Financial distress occurs when an individual or organization isn't making enough money to cover their outstanding obligations. While this condition is typically a bad sign for a person or business' long-term financial health, recovery is still possible. If you're experiencing financial distress, look for opportunities to cut costs, investigate debt consolidation options, and consider working with one of the [best debt relief companies](https://www.investopedia.com/the-best-debt-relief-companies-8763179).