Financial Distress: The Costs That Appear Before Default

Financial distress starts costing money long before anything is missed. Sankalp Industrial Systems Limited, an invented maker of industrial valves, would pay 9.00 per cent rather than 8.00 per cent at a 40.0 per cent debt share. The difference is Rs 9,60,00,000 a year of extra interest, with nothing at all having gone wrong. At a 60.0 per cent debt share the extra is Rs 72,00,00,000 a year.

Financial distress is much easier to feel than it is to define, and a small shop on a busy street is the easiest way in. A household has borrowed against the shop. Every instalment has been paid on the day it fell due. Nothing has been missed, nothing has been renegotiated, and the bank would say the account is entirely regular.

And yet three things have quietly changed this year. The bank renewed the limit at a rate a little above last year's. The wholesaler who used to send goods on thirty days now wants fifteen. The landlord, at renewal, asked for three months of deposit instead of one. Ask the household what went wrong and the honest answer is nothing. Ask what all of that costs and the honest answer is a number, and it is going out of the till every month.

The gap between nothing having gone wrong and money leaving anyway is the whole subject of this guide. Everything below is that shop done to a company and worked to the rupee, and the reason it is worth the trouble is that not one rupee of it will ever be labelled as a cost of distress in any statement anybody files.

What is financial distress, and when does it start costing money?

The confusion worth clearing up first is a confusion between an event and a condition. A defaultAn event: a payment falls due and is not made. is an event. A default has a date on it. A payment falls due on a particular day and on that day it is not made, and everybody involved knows it has happened.

Financial distressThe condition of a company whose possible failure to pay is being priced by the people who deal with it. is not an event. Financial distress is a condition, and it begins the moment the people who deal with a company start pricing the possibility that the company will not pay. Nobody has to announce it, nobody has to agree that it has begun, and it can run for years while every single payment is made on the day it falls due.

Who does the pricing is what decides where to look. The lender does it first and does it in writing, by putting a higher rate into a document that both sides sign. Everybody else does it quietly. A supplier shortens its terms and gives a vague reason. A customer places a smaller order and spreads the rest around. A capable plant manager takes the other offer. None of those people announce that they have repriced anything, and none of them would describe what they are doing as a cost of distress. Shortening terms and moving orders elsewhere is simply how people behave once they have started to wonder.

So the useful question is never whether anything has gone wrong. The useful questions are what is being priced, by whom, and how much of that price is leaving the company in cash this year. All three have answers today. The question about whether an event will happen does not.

Who puts a price on it first, and where is that price written down?

The lender, and in the loan agreement. The loan agreement is the one stroke of luck in this whole subject: of all the costs of distress, exactly one arrives with a number attached and a signature underneath it. Everything else has to be reasoned about.

Sankalp Industrial Systems Limited is a listed maker of industrial valves, precision castings and the aftermarket parts and service that go with them. The company borrows Rs 6,00,00,00,000 today at a blended pre-tax rate of exactly 8.00 per cent, and it sits at a debt share of 25.0 per cent measured at market prices: Rs 6,00,00,00,000 of borrowing against a market capitalisation of Rs 18,00,00,00,000, for total capital of Rs 24,00,00,00,000. Operating profit at Year 0 is Rs 2,40,00,00,000 and the interest bill is Rs 48,00,00,000, so operating profit covers interest exactly 5.00 times. Net debt is 1.67 times earnings before interest, tax, depreciation and amortisation (EBITDA).

Sankalp also carries an invented schedule of what it would pay if it borrowed more or less: one pre-tax rate for each level of borrowing. The schedule repays a close reading. A cost of debt schedule is not really a list of interest rates at all. A cost of debt schedule is a price list for distress, written out in advance by the only party willing to put a number on it.

Reading it as a price list means stripping out the part that is not about this company. Some of any borrowing rate is simply the price of money over time, and the price of money over time is the same for everybody. The worked example assumes a risk-free rateThe yield on a long-dated government security. Here it is an assumed 7.75 per cent, and it is this example's own assumption rather than a market level. of 7.75 per cent, and the amount by which a borrowing rate sits above it is the spreadThe excess of a borrowing rate over the risk-free rate. The spread is the part of the rate that is about the borrower rather than about time.. Spreads are quoted in basis pointsOne hundredth of a percentage point. Twenty five basis points is 0.25 per cent., and here is the whole schedule with its spread beside it, and with the step up from the row above.

Read the last column rather than the second and the shape stops being a list and becomes an argument. From a 25 to a 30 per cent debt share costs 25 more basis points. From 30 to 35, another 35. From 35 to 40, another 40. From 40 to 45, 75. From 45 to 50, a hundred. From 50 to 60, two hundred and twenty five, and that last step covers ten points of debt share rather than five, so even halved it is far and away the steepest.

Each step costs more than the step before it, and that acceleration is the entire point. Money costs what money costs; a lender is not charging more for the rupees because the rupees have become more expensive. The lender is charging for something else, and the something else is the increasing chance that it will not get the rupees back. The acceleration in that last column is the price of distress, written down, in advance, by the one party in the whole arrangement who is paid to put a number on it.

What does the schedule do at the low end, and should that be smoothed over?

The schedule does something inconvenient at the low end, and the honest course is to say so rather than to draw a tidy curve through it. Read the first four rows in order and the schedule goes 8.00 per cent at no debt, 7.75 at a 10 per cent debt share, 7.90 at 20 per cent and 8.00 at 25 per cent. The first four rows are not a rising line but a wobble.

Two things need saying about it. The first is that the top row is notional and should not be used in any claim about the shape at all. At a zero debt share there is no debt, so its 8.00 per cent is the rate this company would be quoted on a first rupee rather than a rate it actually pays on anything. Reading it as the start of a series compares a hypothetical quote with nine real ones.

The second is that from the 10 per cent row upward the schedule is strictly monotonic, and stays that way all the way up: 7.75, 7.90, 8.00, 8.25, 8.60, 9.00, 9.75, 10.75 and 13.00 per cent. So the general claim that every rupee of borrowing raises the cost of debt is contradicted by this schedule's own first rows, and the accurate statement is narrower: below about a 20 per cent debt share the schedule is essentially flat and carries almost no information, and the whole of the shape that matters lies above 40 per cent.

The narrower statement is worth more than the tidy one, and not only because it is true. A reader who has been told that borrowing always raises the rate will look at a company that has just gone from a 10 to a 20 per cent debt share, see fifteen basis points, and conclude that fifteen basis points is what leverage costs. A reader who has been told where the schedule is flat and where it bends will know that the first stretch is not evidence of anything, and will go and look at the part that is.

One small trap sits in this table and it is worth defusing before it confuses somebody. The 10 per cent row reads 7.75 per cent, the same number as the assumed risk-free rate used above. The two are unrelated quantities that happen to share a value in this invented example. Neither is derived from the other, and the coincidence means nothing whatever.

What is all of this worth in rupees, with nothing having gone wrong?

A schedule in per cent is easy to nod at. The same schedule in rupees a year is harder to walk past, so it is worth doing the multiplication twice, at two levels of borrowing, on the same company on the same day.

At a 40.0 per cent debt share this company would carry Rs 9,60,00,00,000 of borrowing, being 40.0 per cent of total capital of Rs 24,00,00,00,000. The schedule prices that at 9.00 per cent, so the interest bill would be Rs 86,40,00,000. At the 8.00 per cent it pays today, the very same borrowing would cost Rs 76,80,00,000. The difference is Rs 9,60,00,000 a year, and it buys nothing. No extra rupee has been borrowed for it, no asset has been acquired with it, and no payment has been missed to trigger it. The difference is the price of being at that level of gearing, charged annually, in advance of any event.

Push it to a 60.0 per cent debt share and the borrowing is Rs 14,40,00,00,000. The schedule prices that at 13.00 per cent, so the bill is Rs 1,87,20,00,000 against Rs 1,15,20,00,000 at 8.00 per cent. The extra is Rs 72,00,00,000 every year, and to see the size of it, this company's profit attributable to owners at Year 0 is Rs 1,38,00,00,000, so the extra interest alone would be 52.17 per cent of what the owners currently receive.

Two labels have to travel with those two numbers. Both figures are arithmetic done on a locked schedule and a locked capital base rather than amounts the record hands over ready made, and both belong to an invented company borrowing at an invented schedule. Both also describe an arrangement the company is not in. Sankalp sits at a 25.0 per cent debt share with cover of 5.00 times, and everything above that row is a computation of what a different arrangement would cost.

Do the shareholders put a price on it too?

The shareholders do, and they price it harder than the lender does. The shareholder half of the story is what catches most readers out. Nobody hands a shareholder a new contract when a company borrows more, so it is tempting to think nothing has changed for them. Something has changed for them: the thing they hold is now a claim on what is left after a much bigger fixed claim has been satisfied.

The residual claimThe shareholders' claim on whatever is left after every fixed claim has been paid. The claim has no stated amount, and that is exactly why its required return moves. is worth watching in rupees rather than in theory. The business does not change when the funding does, so hold operating profit still at the Year 0 figure of Rs 2,40,00,00,000 and put the three interest bills against it. At a 25 per cent debt share, interest of Rs 48,00,00,000 leaves Rs 1,92,00,00,000, or 80.00 per cent of operating profit, and cover is 5.00 times. At 40 per cent, interest of Rs 86,40,00,000 leaves Rs 1,53,60,00,000, or 64.00 per cent, and cover is 2.78 times. At 60 per cent, interest of Rs 1,87,20,00,000 leaves Rs 52,80,00,000, or 22.00 per cent, and cover is 1.28 times.

Look at what happened between the second and third of those. The interest bill roughly doubled and what is left behind it fell by two thirds. The residual claim is being repriced for exactly the same reason the borrowing is, and repriced more steeply. A lender who is not paid is merely late. A residual holder who is not paid has nothing at all.

Where the shareholders' required return sits today is settled elsewhere and is restated rather than rebuilt: this company's cost of equity is 14.00 per cent on a levered beta of 1.25, and its blended cost of all funding is exactly 12.00 per cent. The ladder of required equity returns across the whole range of debt shares, and the effect of the two rising costs together on the value of a business, is worked out under the optimal capital structure. The reason the ladder climbs at all is the reason given just above: less and less is left behind a bigger and bigger fixed claim, and a claim on less is worth less unless it promises more.

How a fixed interest claim amplifies what owners receive in good years and bad is a separate subject again, covered under financial leverage. The argument being made above is narrower and only about pricing.

Why does the one benefit of borrowing shrink exactly when it is most needed?

Borrowing has one clean advantage over equity funding, and the way that advantage fails is the second half of this subject. The advantage is worth stating precisely. Interest is deducted from taxable profit and a dividend is not, so a company that borrows pays less tax than an identical company that does not. The deduction is the tax shieldThe reduction in a tax bill caused by interest being deducted from taxable profit., and Modigliani and Miller put it into the argument themselves, in the American Economic Review in 1958 and in their later correction, having first shown that without taxes and without distress the mix would not matter at all.

On this company today the shield is easy to size. Interest is Rs 48,00,00,000. At the 25.0 per cent effective tax rate this company assumes for itself, the tax bill falls by Rs 12,00,00,000. The saving is real money and it arrives every year.

A condition is attached to it, and nothing else in this subject turns as sharply. A deduction is worth something only if there is taxable profit for it to sit against, so the benefit of borrowing is at its smallest in precisely the conditions that borrowing has made more likely. Work out how far operating profit would have to fall before the shield is worth nothing in a year, and the arithmetic is the same arithmetic as the residual above. At a 25 per cent debt share, profit before tax is Rs 1,92,00,00,000, so operating profit would have to fall 80.00 per cent before the deduction shelters nothing. At 40 per cent it would have to fall 64.00 per cent. At 60 per cent it would have to fall 22.00 per cent.

Set that beside the size of the shield at each level and the shape is uncomfortable. The shield is worth Rs 12,00,00,000 at a 25 per cent debt share, Rs 21,60,00,000 at 40 per cent and Rs 46,80,00,000 at 60 per cent. The shield grows the whole way. And the cushion of profit protecting it shrinks the whole way, from a fall of 80.00 per cent to a fall of 22.00 per cent. The bigger the shelter gets, the smaller the thing holding it up.

Which of these costs appear in no line of the accounts at all?

Everything so far has been a direct cost of distressA cost that shows up as an amount actually paid, chiefly a higher rate on the borrowing.: an amount, in rupees, that leaves the company and can be found in the interest line by anyone who knows to look. Direct costs are the ones that can be computed here, and direct costs are not the large group.

The indirect costs of distressCosts that appear in no line of the accounts, such as deferred investment, weaker terms from counterparties and management attention spent on lenders. are the ones that appear nowhere. A company under strain shortens its horizon and starts deciding things by what the balance sheet will bear rather than by what the business needs. A company under strain negotiates from a weaker position with everybody it deals with, and the people on the other side of those negotiations can tell. Its senior people spend their weeks with lenders instead of in plants and with customers. The staff and the counterparties who have somewhere else to go begin to go there. Jensen and Meckling wrote about the conflicts between the people funding a company and the people running it in the Journal of Financial Economics in 1976, and a company under strain is that argument playing out where anybody can watch it.

None of that is in a cost of debt schedule. None of it is in any covenant, any filing or any statement until long after it has happened, at which point it appears as lower revenue or thinner margin and gets attributed to the market. For all but one of those costs the record holds no number, and an invented one would be worse than a gap left where a reader can see it.

What does a deferred year of investment actually cost?

Sankalp's forecast happens to contain both halves of one calculation, so exactly one indirect cost can be priced here.

Sankalp Industrial Systems Limited puts Rs 1,00,00,00,000 a year of net new invested capitalCapital expenditure less depreciation, plus the movement in net working capital. Here it is Rs 1,00,00,00,000 in every forecast year. into the business in every one of the five forecast years, and its return on new invested capitalWhat each rupee of new capital earns. Here it is an assumed 18.00 per cent, and it is the single most load-bearing assumption in the forecast. is an assumed 18.00 per cent. Multiply the two and profit after tax before interest rises by exactly Rs 18,00,00,000 a year. The locked forecast does exactly that: Rs 1,98,00,00,000, Rs 2,16,00,00,000, Rs 2,34,00,00,000, Rs 2,52,00,00,000 and Rs 2,70,00,00,000 across the five years.

Now suppose a company under strain defers a quarter of that and puts in Rs 75,00,00,000 instead. The deferral is an illustrative assumption rather than something in the record; everything it is applied to is locked. At the same 18.00 per cent, profit now rises Rs 13,50,00,000 a year rather than Rs 18,00,00,000. The shortfall is Rs 4,50,00,000 in the first year. On a company this size that does not sound like much.

The trouble is that it never comes back. The capacity was not built, so the base is permanently lower and every later year starts from the smaller number. Year 2 is Rs 9,00,00,000 short, Year 3 Rs 13,50,00,000, Year 4 Rs 18,00,00,000 and Year 5 Rs 22,50,00,000, or 8.33 per cent below the locked Year 5 figure. Add the five and Rs 67,50,00,000 of profit simply never arrives. A cut that looks like one year of caution is a permanent reduction in the size of the business, and it is the most expensive item in this guide.

Here is the part that makes it genuinely hard to catch, and it is worth sitting with. In the first year the deferral makes the cash flow look better, not worse. Free cash flow to the firm is profit after tax before interest less that net new invested capital, so the locked Year 1 figure is Rs 1,98,00,00,000 less Rs 1,00,00,00,000, being Rs 98,00,00,000. Under the deferral it is Rs 1,93,50,00,000 less Rs 75,00,00,000, being Rs 1,18,50,00,000. The deferred year is Rs 20,50,00,000 higher, and the arithmetic behind it is exact: Rs 25,00,00,000 that was not spent, less the Rs 4,50,00,000 of profit that never arrives.

So in the year the damage is done, every visible number improves. The cash flow is stronger, the reinvestment rate is lower, and the report writes itself: capital discipline. Nothing in that sentence is false. The capacity was still not built.

Who bears all of this, and when do they start paying?

In the end the shareholders bear it, and that part is not surprising: they hold the residual claim, so anything that leaves before them leaves out of what would have been theirs. The interesting half is the timing, and it is the sentence the whole subject turns on.

The shareholders do not start paying when something goes wrong. They start paying the moment the lender prices the possibility. The extra Rs 9,60,00,000 a year at a 40.0 per cent debt share, or the extra Rs 72,00,00,000 at 60 per cent, comes out of operating profit before the residual is struck, so it is gone before the owners see anything. And their own required return has risen at the same time and for the same reason, so what is left is being discounted harder as well. The cost of an event that may never happen is being paid in the present, in cash, every single year, and no part of the payment is refunded if the event never arrives.

The shape is the same in the shop, so go back to it for a moment. The household pays the higher renewal rate whether or not it ever misses an instalment. It funds the larger deposit whether or not it ever gets into trouble with the landlord. The household buys on fifteen days rather than thirty in every single month, not only in a bad one. Nothing has happened, and the household is poorer at the end of every month than it was at the same point last year.

Why does the value curve turn over, and what has to travel with that sentence?

Put the two forces on one drawing and the answer takes one line. One of them grows in proportion to the amount borrowed. The other accelerates. Two lines like that always cross, and where they cross is where more borrowing stops adding and starts subtracting.

Take the deduction first. If the rate never moved off 8.00 per cent, the tax saved would be a quarter of 8.00 per cent of whatever is borrowed, or exactly 2.00 per cent of the borrowing: Rs 12,00,00,000 at a 25 per cent debt share, Rs 19,20,00,000 at 40 per cent and Rs 28,80,00,000 at 60 per cent. A straight line, by construction.

Now the price of distress, measured the same way and net of the deduction it also earns, the extra interest being deductible too. The schedule at the low end charges slightly less than the 8.00 per cent this company pays today, so the price is minus Rs 45,00,000 at a 10 per cent debt share and minus Rs 36,00,000 at 20 per cent. The price is nil at 25 per cent. Then it is Rs 1,35,00,000 at 30 per cent, Rs 3,78,00,000 at 35, Rs 7,20,00,000 at 40, Rs 14,17,50,000 at 45, Rs 24,75,00,000 at 50 and Rs 54,00,00,000 at 60. Not a straight line at all.

The gap between them is widest between a 30 and a 35 per cent debt share, at Rs 13,05,00,000 and Rs 13,02,00,000. The two figures are Rs 3,00,000 apart on a company of this size, and Rs 3,00,000 is not a gap anybody should read anything into. Then the gap narrows, and the two lines cross somewhere between a 45 and a 50 per cent debt share. There is no row between those two, so where exactly is not something this schedule can answer, and interpolating between them would invent a precision the schedule does not carry.

The crossing is the whole reason there is a limit: the benefit of borrowing grows in proportion while the price of distress accelerates, so at some point the second one outruns the first and more borrowing stops being worth having. The pair above is an annual cash comparison of two of the forces, and it is not the finished answer. A full comparison of funding mixes also carries the rising cost of equity set out above, and it discounts the whole stream rather than one year of it. The fuller build, and the level of borrowing at which it turns, is worked out under the optimal capital structure.

Two things have to travel with any sentence about where that turn sits. The first is that the turn is flat near the bottom. The cash comparison above moves by Rs 3,00,000 across a whole five points of debt share near its widest, and the fuller build behaves the same way, so the precision of any stated answer is far lower than the precision of the arithmetic that produced it. Quoting such a point to one decimal place claims an accuracy that is not there.

The second is that the whole shape belongs to the schedule. Nothing else in the calculation is doing any work, so change the cost of debt schedule and the crossing moves. The schedule belongs to this invented company alone, and a reader who carries a number away from it as a general answer for any company has misread the worked example rather than learned from it.

What travels to another company, and what does not?

Three things travel and two do not. The first is the distinction between a condition and an event, and that distinction is the whole of why anybody looks in the wrong place. The second is the division of the costs into the one group that is written down and the larger group that never is. The third is the method: convert a rate into rupees a year, and convert a deferred investment into the profit growth that never happens. A percentage is easy to nod at and a rupee figure is not.

No number above travels. The two anchor figures of Rs 9,60,00,000 and Rs 72,00,00,000 a year are arithmetic on one invented schedule, and the deferral of a quarter of the reinvestment is an assumption made to illustrate a mechanism. No conclusion about a company travels either: a schedule prices a possibility, and a priced possibility is not a finding that the possibility will occur. Sankalp sits at a 25.0 per cent debt share with cover of exactly 5.00 times, and every row above that is a computation of what a different arrangement would cost, not a forecast that it will happen.