Financial Distress & Bankruptcy

When a company has trouble paying its bills it is considered to be in a state of financial distress. If the company cannot find a way to come up with enough money, it might be forced to declare bankruptcy, an orderly process of restructuring debt and assets that is overseen by the courts. The exact rules that govern bankruptcy proceedings vary from country to country.

A company's hard debts are those that it must pay at a set time. Servicing a debt, making regular payments to suppliers, and paying employees their wages and other benefits are all examples of hard debt contracts.

A company's liquidity can be defined as the amount of actual cash it has on hand plus the total value of goods that can quickly be sold at or very near their full value. When a company needs to pay more than its total liquidity to meet its hard debt contracts, that company is said to be in financial distress.

When a company is in financial distress, it usually has only a few options. A company can sell assets that would normally be seen as non-liquid. The difference between the sale price and the expected long-term value of the assets represents a net loss for the company.

The debt might also be restructured by pushing payments into the future, reducing the total amount of debt or changing the hard debt contract to a soft debt contract.

Any of these options requires consent from the company's creditors. If it can acquire outside funds, such as from a new loan or from private equity, the company can use that money to pay off its other debts.

Although financial distress could theoretically be handled outside of courts, bankruptcy law exists to protect the company and its creditors. The creditors can take the company to court to force payment on a company's debts, while a company in financial distress can declare bankruptcy to protect itself from creditors who are more concerned with receiving immediate payments than with the future viability of the distressed company. In some cases the distressed company might have to be completely dismantled, but in many countries, bankruptcy law explicitly tries to avoid that.

In the United States, bankruptcy proceedings are handled by special bankruptcy courts, which are a part of the federal court system. Companies have the option of filing for Chapter 7 protection, which results in total liquidation of the company, or for Chapter 11, which allows the company to be restructured instead, although significant assets might end up being liquidated.

During bankruptcy proceedings, creditors are ranked according to the absolute priority rule, meaning that the most-senior claim will be repaid in full before the next most-senior claim receives any payment. Creditors can go to court to attempt to force Chapter 7 bankruptcy, but the company's management will usually be allowed to file Chapter 11 instead. If there are too many creditors to be represented in court, different types of creditors might each be represented by representative committees.