Comment on the following: Financial distress is different from insolvency.

The affairs of a firm should be managed in such a way that the total risk-business as well as financial-borne by equity holders is minimized and is manageable; otherwise, the firm would obviously face difficulties. If cash inflow is inadequate the firm will face difficulties in payment of interest and repayment of principal. If the situation continues long enough, a time will come when the firm would face pressure from creditors. Failure of sales can also cause difficulties in carrying out production operations. The firm would find itself in a tight spot. Investors would not invest further. Creditors would recall their loans. Capital market would heavily discount its securities. Thus, the firm would find itself in a situation called distress. In general, insolvency occurs subsequent to a period of financial distress. Many a times, if financial distress is identified in time and remedial action taken, possibility of insolvency can be completely avoided. There is no accepted definition of financial distress but the key indicators of financial distress can be low interest coverage ratio, missed dividend payments, negative EBIT. Insolvency by contrast, is a decision which the business chooses to take to relieve itself from excess debt burden. It is a decision where the firm decides to sell its assets to discharge its obligations to outsiders at prices below their economic values i.e., resort to distress sale. So when the sale proceeds are inadequate to meet outside liabilities, the firm is said to have failed or become bankrupt or (after due processes of law are gone through) insolvent.