Financial Distress

  

The dinner bill came. You had no idea that bottle of bold California cab would cost $350. Financial distress ensues.

When companies are feeling stressed...like, they aren't making enough in basic profits from the business to pay the interest on their debts...or they are losing money, we (and they) call it “financial distress.”

How do companies get themselves into these financially stressful situations? Bad products. Bad management. Bad market timing. Bad luck.

See: Chapter 13. See: Bankruptcy.

Related or Semi-related Video

Econ: What was the Great Depression?15 Views

00:00

and finance Allah shmoop What was the Great Depression Okay

00:08

So what is the Great Depression Yes yes it's the

00:11

feeling you get after a major break up You know

00:13

where you sit in front of the TV for twelve

00:15

hours at a time shoving massive amounts of Cheetos in

00:17

your mouth and obsessively checking your ex's instagram feed one

00:21

form of great Depression But the Great Depression we're talking

00:25

about here describes a key period in the twentieth century

00:27

Specifically the Great Depression represents the worst economic downturn in

00:32

American history Ever wonder why your great grandpa spent so

00:36

much time burying Mason jars filled with quarters in the

00:39

backyard while obsessively mumbling about those *** banks While starting

00:44

in the late nineteen twenties the Great Depression lasted until

00:46

in the early nineteen forties really ending Justus America for

00:50

ever cared for entry into World War two The Depression

00:53

included mass unemployment widespread bank shut down There were significant

00:58

foreclosure like people getting kicked out of their homes Then

01:01

there was starvation and well just long lasting financial trauma

01:05

So first a bit about the name When economic conditions

01:08

are good and the economy is growing That's called an

01:11

expansion when the economy slows down While that's known as

01:14

a recession if a recession last for a long time

01:18

and gets particularly bad well then it becomes a depression

01:22

And when a depression goes on for well over a

01:24

decade and it spreads throughout the world where it contributes

01:28

to mass political dislocation which eventually feeds into the causes

01:31

of World War Two well then it becomes the Great

01:34

Depression Great Not in a good way Well it's nineteen

01:37

eighteen World War is over The countries of Europe were

01:41

bombed out and bankrupt Thank you Germany and the U

01:44

S Emerged from the war is the key economic power

01:47

in the world Now it's the nineteen twenties US is

01:50

the centre of world economy The jazz age is in

01:53

full swing Gatsby is there hosting lavish parties in West

01:57

Egg Babe Ruth is partying down with Charlie Chaplin in

02:01

a C speakeasy owned by Al Capone The U S

02:04

Is benefiting from a boom and consumer products and rapid

02:07

expansion of technological improvements like radios That was high tech

02:10

in those days There were cars there were refrigerators Yeah

02:14

they're all becoming common household items and we made him

02:17

we exported him well Meanwhile financial speculation runs rampant You

02:21

could make a killing in a Florida land deal or

02:24

by booming tech stocks like RC A right the Radio

02:28

Corporation of America But things started to get shaky toward

02:31

the end of the decade late nineteen twenties commodity prices

02:34

have been falling for some time leaving farmers who sell

02:37

the ultimate commodity you know coloring turnips wheat out of

02:40

much of the prosperity of the nineteen twenties Meanwhile the

02:43

stock market was pumped up by unstable margin trading Basically

02:47

people have been borrowing money to bet on stocks A

02:51

trader has a thousand bucks in his account His broker

02:53

lets him borrow another five hundred dollars on margin Margin

02:57

just means that the trader is allowed to borrow money

02:59

to purchase more stock The shares of stock become the

03:01

collateral for the money he borrowed If the broker ever

03:04

wants the money back the cash ola while the broker

03:07

can then make a margin call meaning that the broker

03:10

Khun demand that the investor there a trader sell his

03:13

stock immediately in order to pay the money back Well

03:16

the system works well when the stock market's going up

03:18

up But as you can imagine it can lead to

03:21

disaster when stocks decline quickly So first look at how

03:24

it works in the good times The trader has a

03:26

thousand dollars worth of equity but takes on five hundred

03:29

bucks in margin So all in that Khun by fifteen

03:32

hundred dollars worth of stock purchasing hundred shares of Amalgamated

03:35

Fedora Ink at fifteen dollars each stock goes up twenty

03:39

Trader then sells the stock for two thousand dollars pays

03:42

back the five hundred bucks he borrowed plus and maybe

03:45

twenty five bucks and interest Then he keeps the additional

03:47

profit well The trader just made four hundred seventy five

03:50

dollars from his thousand dollars of equity position or thousand

03:54

dollars in stock for the owned That's forty seven point

03:56

five percent return even though the stock only went up

03:59

a third like thirty three percent Well the additional dough

04:01

from the margin account further inflates the stock bubble of

04:04

the nineteen twenties but it also makes the bubble Mohr

04:07

unstable Well margin in those days acted to pump up

04:10

the profits when stock market rose but it also acted

04:12

to deepen the pain When stocks went down traders lost

04:16

more than they had and brokers got caught with large

04:19

amounts of outstanding debt that well nobody could pay back

04:22

Same traders Same thousand dollar account same five hundred dollars

04:25

margin All invested in one hundred shares of Amalgamated Fedora

04:29

Ink at fifteen bucks a share But now the doomsday

04:31

scenario The bubble bursts Amalgamated food or a drop from

04:34

fifteen dollars a share too four dollars a share The

04:37

broker makes a panic margin Call the trader sells his

04:40

hundred shares and gets the four hundred bucks It's all

04:42

he can get Well now he's lost eleven hundred dollars

04:46

on his thousand dollar account The brokerage is still owed

04:49

one hundred dollars The broker is on the hook for

04:51

that hundred dollars but the brokers also loaned the same

04:54

margin to one hundred other clients Each of them are

04:56

also one hundred bucks in the hole So now the

04:59

brokerage there's ten grand in the hole in the economy

05:02

The nineteen twenties cheap credit pumped up other parts of

05:04

the financial industry It wasn't just the stock market Speculation

05:08

ran rampant Creating an unstable system Susceptible The shocks like

05:12

that Which brings us to nineteen twenty nine right here

05:15

the troubles culminate in a massive stock market crashed It's

05:18

not the plunge in stock prices that causes the Great

05:21

Depression but the crash acts as a curtain raiser for

05:24

much of the hardships to men Calm following the Wall

05:27

Street bloodbath things quickly get bad for the rest of

05:31

the economy Like businesses collapse unemployment skyrockets Banks begin to

05:36

fail There are mass foreclosures and bankruptcies So what happens

05:39

here Late twenties early thirties It's Grapes of Wrath time

05:43

Yeah the people in charge like President Herbert Hoover and

05:46

the Federal Reserve Well they don't really know how to

05:48

deal with this kind of downturn Previous economic panics have

05:51

occasionally been sharpened painful but they've always corrected themselves quickly

05:54

Not after nineteen twenty nine Things just keep getting worse

05:58

over the coming years Announced nineteen thirty two Election year

06:01

President Hoover is defeated by FDR Franklin Delano Roosevelt FDR

06:05

gets elected on the promise of a new deal a

06:08

series of measures meant to re invigorate the economy and

06:11

regain confidence in the finance industry Well FDR in a

06:14

newly elected Congress immediately started passing relief actions Banking reform

06:19

government regulation finance regulation Also government start spending money on

06:25

relief efforts and projects meant Teo get people backto work

06:28

well The new Deal takes its inspiration from British economist

06:31

John Maynard Keane's He theorized that governments should combat economic

06:35

troubles with deficit spending in an effort to stimulate demand

06:38

and give business a kick start after nineteen thirty two

06:41

while things improve though a full recovery takes the rest

06:44

of the decade Ultimately the preparations ahead of World War

06:47

Two and eventually the boost from all of this spending

06:50

pulled the US out of the Great Depression So yeah

06:54

it didn't even need to go to counseling Uh oh

Up Next

Finance: What is Bankruptcy?
260 Views

What is bankruptcy? Deadbeats who can't pay their bills declare bankruptcy. Either they borrowed too much money, or the business fell apart. They t...

Finance: What is the Student Loan Crisis?
24 Views

What is the student loan crisis? The student loan crisis describes the situation that faces our country; namely the fact that there is over a trill...

Find other enlightening terms in Shmoop Finance Genius Bar(f)