Financial Distress Overview, Determinants, and Sustainable Remedial Measures: Financial Distress

Financial Distress Theories

There are several theories that have been used to explain financial distress in finance management literature. For instance, the cash management theory postulates that the continuing imbalance between the cash outflow and cash inflow would result in financial distress in an organisation (Aziz & Dar, 2006). The imbalance in the cash flows arises due to cash management failure. The theory is of the opinion that for firms to avoid distress situation, there is a need for effective and efficient utilisation of fund. Improper cash management leads to an imbalance between the cash inflows and cash outflow and this often leads to financial distress in firm.

The theory of credit risk is another theory that is used to explain why financial distress occurs in firms. This theory states that when firms do not properly manage their credit risk, it might lead to the firm becoming financial distress. Credit risk refers to the potential that a counterparty will not honour its obligation as agreed. Credit risk directly threatens the continued survival of an organisation and if not properly managed leads to distress situation in firms. An organisation needs to have a sound credit risk management framework to be able to identify, assessed and control credit risk in an organisation. Developing a sound credit risk management framework also involve having a good credit risk policy. One of the early signs of financial distress is when an organisation has a high credit risk.