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FRM Part II · FRM Exam Part II · Distress Symptoms and Remedies

A risk manager at a fund holding the bonds of an industrial company wants to separate financial distress from economic distress. Which situation best describes financial distress rather than economic distress?

Financial distress is a firm with fundamentally viable operations that cannot meet its debt obligations because of excessive leverage or a liquidity gap. Economic distress involves impaired operations, such as obsolescence or structural decline. Financial distress can be remedied by restructuring the capital structure, while economic distress usually cannot.

  1. AA firm whose operating assets earn less than their cost of capital because demand for its product has permanently fallen
  2. BA firm with viable operations whose earnings are sound but whose heavy debt load means it cannot meet scheduled paymentsCorrect
  3. CA firm whose industry is in structural decline and whose plants are worth more closed than operating
  4. DA firm whose products have become obsolete because of a new technology

Explanation

Financial distress arises from an unsustainable capital structure (too much leverage or a liquidity shortfall) in a business whose operations are fundamentally viable. The other options describe economic distress, where the underlying business itself is impaired. Restructuring the balance sheet can cure financial distress but not economic distress.

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