A company can be likened to a human body. Financial distress and corporate collapse is usually dramatized in the media as a sudden occurrence, but this is almost never the case. There is usually ample warning of impending doom, but many companies either ignore the warning signals or try to hide the problems using creative accounting.
Financial distress refers to a problem, usually of a financial nature which causes the cash flow position of a company to deteriorate. With proper diagnosis and treatment, this problem can be resolved and the company restored to financial health.
The first visible sign of financial distress occurs when a company falls into arrears of interest and loan repayments, there is delay in payment to suppliers, there is a shoddy look to the office and the staff stop being paid on time.
In some countries, companies are not allowed to fail, even though they may be financially distressed. Companies are propped up by a continuous injection of funds in order to preserve jobs. Unfortunately, while cash flow problems may be a problem, investing more money is rarely the solution. A sustainable solution needs to combine investments with more drastic treatment. Failing this, the company will drag on in meaningless existence as good money is thrown after bad.
On the converse side, free market economies dictate that the law of survival of the fittest prevails.
Can financial distress be prevented?
Financial accounts and reports are supposed to serve the purpose of alerting management to any problems inside the business. However, such reports are usually guilty of hiding a large amount of information from company outsiders. The report may fulfil statutory obligations, but it is often a poor indicator of the company’s health.
The auditor and the accountant may have a role to play, but their usefulness is often limited in the face of corporate politicking and executive greed. The only way of effectively preventing financial distress is to create a system that gives early warning of an impending financial problem.
Management research shows that financial distress may be prevented when the company has a good management team, a solid corporate strategy and a resolute Chief Executive. Consequently, effective corporate governance plays an effective role in effective business management.
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