Financial distress occurs when an organization is unable to pay its creditors and lenders. This condition is more likely when a business is highly leveraged, its per-unit profit level is low, its breakeven point is high, or its sales are sensitive to economic declines. Because of this condition, other parties will typically engage in the following actions:
Suppliers require that any additional payments be made with cash on delivery (COD) terms
Lenders will not extend any additional loans
Customers cancel their orders or do not place new orders
Competitors try to steal away customers
To get out of the situation, managers may be forced to sell assets on a rush basis, lend their own money to the firm, and/or eliminate discretionary expenditures. Another problem is that employees will be much more likely to look for work elsewhere, so there is a rapid decline in the level of institutional knowledge within the business.
Financial distress is common just before a business declares bankruptcy. If the level of distress is high, the firm may be forced into immediate Chapter 7 liquidation, rather than attempting to work out a payment schedule with creditors and lenders.