Chapter 30, Problem 1CQ

Summary Introduction

To explain: Financial distress using the stock-based and flow-based approaches.

Financial Distress:

Financial distress is a situation where the funds or revenue generated by the company through its cash flow activities is not sufficient to meet its current business obligations.  It is the situation when the firm is not being able to pay its debts because neither the operating nor financing and nor the investing activities of the company are able to meets its obligations and run its business smoothly. Therefore, the acute shortage or lack of funds leads to financial vacuum being created in the firm which is known as financial distress.

Answer to Problem 1CQ

• Although financial distress can generally be taken as lack of funds to fuel, the activities of the business but there are two different approaches to analyze the financial distress. The first is the stock-based financial distress. In the stock based financial distress the assets of the company are relatively of lesser value than the value of company’s debts.
• This situation of excessive debt than the available assets leads to negative net worth of the company, which ultimately leads to the inability to meet any kind of obligations and a pressure, or distress of shortage of finance is created.
• Flow-based financial distress is a situation whereby the revenue generated by the operating activities of the business is not ample to meet the current debt obligations of the company. The operating activities are the core activities of the business and lack of revenue through the same reflects the poor performance of the business.

Explanation of Solution

• Financial distress means the situation where the funds generated by the company through its different business activities are not sufficient to meet the business obligations and eventually the business faces a vacuum of funds.
• Financial distress through stock based approach is a situation where the actual assets’ value held by the company is relatively lower than the liabilities faced by it.
• Flow-based financial distress directly displays the poor performance of the operating activities of the business and that the funds generated by it are insufficient to meet its current debt obligation.

Conclusion

Thus, the above mentioned are the different approaches of financial distress.