How to Calculate Cost of Financial Distress

Financial distress is not uncommon in tough economic times. Companies must figure out new ways to generate income and cut costs. While assets don't cost more when a company is in financial distress, the money borrowed to finance the assets may be more expensive. It is not uncommon for financial institutions and banks to increase the rate charged for borrowed funds when a company is in financial distress. The difference between the new and old cost of funds is the cost of financial distress.

Obtain the annual report. The annual report can be downloaded from the company's website or you can request an annual report by contacting the Investor Relations department.

Calculate the total amount of debt. This includes current (due in less than one year) and long-term debt. You can find this information on the balance sheet.

Determine the rate of interest paid by firms that are not in financial distress in the same industry. These are firms with a AAA credit rating from analysts and credit-rating firms such as S&P and Moody's. The best way to look up the cost of debt for these firms is to research the rate these firms pay on their bonds. You can do this by calling the Investor Relations department for the company, looking up the information on the company website or calling your financial adviser for a quote. Assume the interest rate paid to investors for a high credit quality bond (AAA) is 6 percent.

Calculate the weighted average cost of debt. Assume the company has $1 million in loans and the interest rate for $250k has been raised to 8 percent due to financial distress and the interest rate on the other loan for $750k has been raised to 10 percent due to financial distress. The weighted average interest rate is calculated by finding the percentage of the loan and then multiplying by the interest rate. For instance, $250k represents 25 percent of $1 million. .25 multiplied by 8 percent is 2 percent. $750k represents 75 percent of $1 million. .75 multiplied by 10 percent is 7.5 percent. 2 percent plus 7.5 percent is 9.5 percent which is the weighted average cost of debt.

Subtract the cost of debt for the AAA rated company from the weighted average cost of debt for your company. In this example, the calculation is 9.5 percent minus 6 percent or 3.5 percent. This is the cost of financial distress in percentage terms.

Calculate the cost of financial distress in dollar terms. Multiply the cost of financial distress in percentage terms by the total debt amount. The calculation is 3.5 percent multiplied by $1 million. The answer is $35,000.

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About the Author

James Collins has worked as a freelance writer since 2005. His work appears online, focusing on business and financial topics. He holds a Bachelor of Science in horticulture science from Pennsylvania State University.