Indirect Costs of Financial Distress
Cláudia Custódio, Miguel A Ferreira, Emilia Garcia-Appendini
Review of Finance, Volume 27, Issue 6, November 2023, Pages 2233–2270, https://doi.org/10.1093/rof/rfad014
In the presence of information asymmetry, contractual frictions, or other conflicts between the firm and its stakeholders, a firm facing financial distress might experience a reduction in sales.
This paper estimates the indirect costs of financial distress due to lost sales. When firms experience financial distress, their clients might decide to decrease exposure by reducing purchases, which also reduces the revenue of the supplier. We exploit real estate shocks and cross-supplier variation in real estate assets and leverage as a source of financial distress.
To estimate the ‘lost sales’ without those being affected by demand-side fluctuations, we compare across suppliers of the same client. We show that for the same client buying from different suppliers, the client’s purchases from distressed suppliers decline by an additional 13% following a negative shock to local real estate prices. The estimated effect is more pronounced in more competitive industries, manufacturing, durable goods, less-specific goods, and when the costs of switching suppliers are low. This is plausible as we expect clients to further reduce their exposure to the supplier in such cases. Our results suggest that indirect costs of financial distress are sizable.