Determinants of financial distress a study of listed companies in vietnam

MINISTRY OF EDUCATION AND TRAININGUNIVERSITY OF ECONOMICS HOCHIMINH CITY ---TRẦN THỊ KIM PHƯỢNG DETERMINANTS OF FINANCIAL DISTRESS: A STUDY OF LISTED COMPANIES IN VIET NAM ECONOMICS MAS

MINISTRY OF EDUCATION AND TRAINING

UNIVERSITY OF ECONOMICS HOCHIMINH CITY

-TRẦN THỊ KIM PHƯỢNG

DETERMINANTS OF FINANCIAL DISTRESS: A STUDY OF LISTED COMPANIES IN VIET NAM

ECONOMICS MASTER THESIS

Major: Business Administration

Ho Chi Minh City - 2012

MINISTRY OF EDUCATION AND TRAINING

UNIVERSITY OF ECONOMICS HO CHI MINH CITY

-TRẦN THỊ KIM PHƯỢNG

DETERMINANTS OF FINANCIAL DISTRESS: A STUDY OF LISTED COMPANIES IN VIET NAM

ECONOMICS MASTER THESIS

Major: Business Administration

Major Code: 60.34.05 INSTRUCTOR: Võ Xuân Vinh, Ph.D

Ho Chi Minh City - 2012

ABSTRACT

This study focuses on researching the relationship between a setfinancial ratios and the probability of failure companies Through the Logisticregression method, the results show that EPS, Cash per shares and Assetturnover are the most important financial ratios, which help investors toidentify the financial distress of listed companies in Vietnam Stock Exchange

During the time for conducting my thesis, I have been stronglysupported by many people Through these words, I would like to extend mysincere to all of them The first one I would like to express my sinceregratitude is my direct supervisor PhD Vo Xuan Vinh, who provides me hisgreat guidance day by day until completing the thesis

The next ones I would like to express my special gratitude are myfamily, who are always by my side and encourage me if necessary

Last but not least, my thesis would be nothing without the enthusiasmand information from my friends

Tran Thi Kim Phuong

Ho Chi Minh City, December 2012

STUDENT DECLARATION

I hereby declare that the content in this thesis is my own, except forspecial references, quotations and summaries All data, references using inthis research are clearly identified The thesis has not been accepted for anydegree until now

SIGNED:

DATE:

TABLE OF CONTENT

ABSTRACT i

ACKNOWLEGEMENTS ii

STUDENT DECLARATION iii

TABLE OF CONTENT iv

LIST OF TABLES vi

Chapter 1: Introduction of the study 1

1.1 Rationale of the study 1

1.2 Research objectives and questions 4

a) Research objectives 4

b) Research questions 4

1.3 Structure of the study 4

Chapter 2: Literature Review 5

2.1 Definition of financial distress 5

2.2 Ratios in designing models 9

2.3 Techniques used in financial distress predictions 12

2.4 Hypotheses 15

2.5 Conclusions 16

Chapter 3 Research Methods 17

3.1 The model 17

3.2 Selection of predictor variables 18

3.3 Data set 20

Chapter 4 Data analysis and Findings 23

4.1 Descriptive Statistics 23

4.2 Correlations 24

4.3 Regression model 25

Chapter 5 Conclusions 30

5.1 Summary 30

5.2 Limitation of the research study 31

REFERENCES 33

APPENDICES 36

LIST OF TABLES

Table 1 Summary statistics 23

Table 2 Variable correlation 25

Table 3 The performance of logistic regression for 8 models 26

LIST OF ABBREVIATIONS

HOSE: Ho Chi Minh City Stock Exchange

MDA: Multiple Discriminant Analysis

ANN: Artificial Neural Networks

WOCA: Working capital

GROPROM: Gross profit margin

EPS: Earnings per share

DEBTTOTAL: Total debt to total assets

CASPSHARE: Cash flow per share

ATURNOVER: Asset turnover

SALEPERCA: Sales per cash

SALEPERRE: Sales per receivables

Chapter 1: Introduction of the study

1.1 Rationale of the study

The concept of “stock market” in the modern economy is the locationfor the trading activities of medium and long – term securities The marketparticipants including individual and institutional investors such as the mutualfunds and the insurance companies perform the purchases and sale of stockfor many different purposes involved in a good profit or taking over thecontrol of the enterprise However, the most benefit from the establishment ofstock market is to bring the flexible source of capital financing the business’operations For this reason, hundreds of the stock market has been set up afterthe first one, New York Stock Exchange (NYSE), and contributedsignificantly to the national economies

With the awareness of the stock market’s important role, the SecuritiesTrading Center in Ho Chi Minh City, now called Ho Chi Minh City StockExchange (HOSE), was established under the Decision No 127/1998/QD-TTg dated 11/07/1998 and formally put into operation on 28/07/2000 withonly two listed companies From now on HOSE has many remarkableachievements For example, until 31/12/2007, there were about 507 listedcompanies with a total market value of 365 trillion, 3 securities investmentfunds and 366 the variety of bonds The number of investor accounts opened

at the securities companies were nearly 298 thousand accounts including over

7000 foreign investors Vietnam Index, which represents the performance ofVietnamese companies trading on the Ho Chi Minh Stock Exchange, has

increased continuously in that period This is the most splendid stage in the development of Vietnam Stock Exchange.

However, after a rapid and hot growth, the Vietnamese Stock Market in

2008 ended with a sharp decline and many listed companies have faced tofinancial difficulties Under the major impact of the economic crisis, the totalprofit of all listed companies decreased to 30% At the end of 2009, 23 out of

329 listed companies announced loss

The financial distress companies can cause some great damages to themarket participants such as shareholders, creditors, managers, especiallyindividual investors How do these investors protect them from this baddamage? Through many researches, one conclusion is declared that firms inthe financially distress state have some particular characteristics relevant tolosses, a high leverage, low and volatile stock returns, etc Recognizing thesesigns is a way for warning not only investors but also enterprises in operation

as well Thus, there have been a number of qualitative and quantitativeresearches conducted to identify failing firms

However, the two most popular methods are Multiple DiscriminantAnalysis and Logistic regression These techniques combined with a set offinancial ratios come up with the most famous two models, Altman’s Z scoremodel (Altman 1968) and Ohlson’s model (Ohlson 1980) The research byBeaver (1966) and Altman (1968) focus on the main problem that is thepredictable ability of model developed from financial ratios Based on thisclassic research, the Z score model have been developed carefully throughfurther studies of some researchers including Deakin (1972), Taffler ( 1985 ),Goudie (1987), Grice and Ingram (2001), Agarwal and Taffler (2007), andSandin and Porporato (2007)

Similarly, other studies also have been performed relating to theOhlson, including Lau (1987), Fauzias and Chin (2002), Boritz, Kennedy, andSun (2007), Muller, Steyn-Bruwer, and Hamman (2009).

Nowadays, these financial distress techniques have been applied formany economical purposes One of them is for credit analysis in financialinstitutions If customers want to borrow loans, the financial institutionsevaluate the credit worthiness of customers In case of detecting the potential

of falling into financial distress, some preventive methods may beimplemented For example, they can reject loan applications or borrowersmust take more steps aiming to avoiding loan defaults before receivingmoney

So which technique is the precise one? That is the argumentativequestion Each of them has its own advantages and disadvantages Theeffectiveness of the methods might be high or low at different times Thereason for this is that a person’s reaction to information is difficult to forecast

In a person’s behaviors, some basic trends and random elements stay together.With a collection of millions of investors, the probability of forecasting theirbehaviors is not as exact as predicting one person’s behaviors Results fromeach research also depend on other factors such as the characteristics of eachstock market, time for collecting data, etc

For a long time, applying these techniques in predicting financialdistress to Vietnam Stock Exchange is still not much while many publiclylisted companies have fallen in to this stage As a result, it is worthy toprovide a research aiming to investigate the role of financial ratios inpredicting financial distress, which is definitely relevant and useful for both

private entities and governmental institutions for assessing firms’ financial condition as well.

1.2 Research objectives and questions

a) Research objectives

By means of the prior researches, the thesis’ primary objective is toclarify the relationship between financial ratios and the financially distress oflisted companies in Viet Nam

b) Research questions

- Which is the suitable method to evaluate the impact of financial

ratios on the probability of failure ?

- How is the relationship between the financial ratios and the financial

distress state of companies?

1.3 Structure of the study

This research is divided into 4 chapters Chapter 1 relates to introducethe general content of the research with research problem, research questions,and research objectives A literature review of the financial distress prediction

is scanned in Chapter 2 Chapter 3 reveals analyses the data collected, and thefinal result of the research Chapter 4 discusses conclusions and implications

of the research

Chapter 2: Literature Review

2.1 Definition of financial distress

It can be said that there are many definitions used in researchesregarding financial distress Dun and Bradstreet (1985) clarify the financialdistress as the discontinuity of the business operation To Foster (1986), acompany is in financial distress when it has serious liquidity problems settledthrough crucial changes in entity’s operation Liquidity problem is known as astate where all company’s current obligations can not be strictly enforced.There also have been definitions of financial distress like reduction ofdividend and defaults on debt

Moreover, some stages of financial difficulty are introduced throughmany researches such as three stages in Guthmann and Dougall (1952) withtechnical insolvency, debt burden unsupportable and reorganization; fourstages of deterioration in Newton (1975) including incubation, cash shortage,financial insolvency and total insolvency Lau (1987) employs the five-statemodel to discover the financial distress while Somerville (1989) chooses athree - state model

In general, “financial distress” is a term indicated a condition whencommitments to creditors of a company are broken or in difficulty.Sometimes financial distress can lead to insolvency Thus, it requires eachgovernment in every country to issue some regulations on dealing withfinancial distress in the corporate sector That is one of the reason why thereare quite much discussions defining failure legalistically This kind ofdefinition has a dominant advantage that it provides researches criterion toeasily classify the distress and non – distress firms in the population being

examined For instance, in the study related to Malaysia Stock Exchange, the financial distress companies are defined according to the following options:

a) Closing down under Companies Act 1965;

b) Committing to a Scheme of Arrangement and Reconstruction;c) Restructuring debt under Corporate Debt Restructuring

Committee;

d) Selling the firms’ loans; and

e) Restructuring small borrowers

To one research in United Kingdom, fail firms are selected in accordancewith some regulations in Insolvency Act of 1986 They are five courses ofaction: administration, company voluntary arrangement, receivership,liquidation and dissolution

In Viet Nam, according to the Law on the Bankruptcy of the NationalAssembly released dated 15 June 2004, a company is filed for bankruptcybecause of not being able to pay the debt when it is due However, thiscompany still has a chance to recover its operation prior to the time when theHigh Court declares bankruptcy All creditors organize a Conference toappraise, adjust the company’s rehabilitation plan for production andpayment It encompasses a wide range of following measures:

a) Mobilizing new capital;

b) Changing production commodity;

c) Technological innovation in production;

d) Reorganizing the management system; merging or splitting theproduction department to improve productivity and quality of

production;

e) Selling shares to creditors;

f) Selling or leasing dispensable assets.

In fact, it is rare to find the detail of information that Vietnamese firmdeclared a state of bankruptcy in the High Court One of the main reasons isthat the administrative procedure regardless of bankruptcy is quitecomplicated and collecting information relating these companies are verydifficult The public listed companies in the Ho Chi Minh Stock Exchange,during over fifteen–year operation, have not been obliged to file forbankruptcy, although some of them stay into the pessimistic financialsituation

To promote efficiency and credibility of the stock market as well asguarantee the interest of the directors, intermediates and shareholders, the HoChi Minh Stock Exchange introduces the Decree 04/QD-SGDHCM dated 17April 2009 on Amendment of and Addition to a number of Articles ofRegulations for listing Similarly to the Ho Chi Minh Stock Exchange, the HaNoi Stock Exchange brings in the Decree 324/QD-SGDHN dated 04 June

2010 on Declaration of Regulations for listing According to this law, thesecurities with unsatisfactory conditions are classified into cases that thesecurities are warned, put under control, stopped trading and delisted TheStock Exchanges use warning signs and makes full disclosure on the marketfor the above securities Removing warning signs are considered in case oflisted companies that overcome causes for being warned, put under control,stopped trading and delisted

Some underlying conditions of classification pursuant to the law for eachcase imply the finance nature such as:

a) The case for warned stocks:

 There is a one-year-overdue debt or a rate of overdue debt higherthan 10% equity.

 There are not enough 100 shareholders holding at least 20% shares

of the company

 The earning at the same year is negative

 The company’s operation is stopped

 Listed companies continue to violate the regulations in relation to disclosing the information although being warned

 Shares do not trade within 90 days

 It is deemed necessary to protect the benefit of investors

b) The case for stocks put under control:

 Listed companies have not improved situations leading them to beingwarned

 Listed companies violate regulations involved in stocks and the stock market seriously

c) The case for delisted shares:

 The charter capital decreases to below 80 billion VND

 Listed organization’s certificates of business registration orcertificates in specialized business are revoked

 Shares have not traded in 12 months

 Audition organizations have disapproved of or refuse to give idea of listed firms’ latest financial statement

 The earnings after tax are negative For example, if the listedcompany has negative earnings for three consecutive years and thetotal accumulated losses exceeds the equity in the financial statement

at the latest, this company will be deleted from the Ho Chi Minh

Stock exchange – the action of delisting The listed firms stop tradingwhen their earnings for two consecutive years are negative.

Due to difficulties in finding annual financial statements for listed companies, the financial distress firms are companies whose shares were put under control or delisted according to the Decree 04/QD-SGDHCM dated 17 April 2009 on Amendment of and Addition to a number of Articles of Regulations for listing and Decree 324/QD-SGDHN dated 04 June 2010 on Declaration of Regulations for listing.

2.2 Ratios in designing models

According to Foster (1986), applying a ratio in detecting financialdifficulties of companies is the most appropriate approach because of theability to use regularities in the relationship between the ratio and an event ofinterest Ratio models are derived from financial statements whose ratiosdiffer from stable and unstable firms However, performing financial ratiosneed to pay more attention because of the interpretation of accountingstandards as a base for financial reports

As regards collecting financial ratios as predictor variables, it depends onthe popularity and the ability to predict in previous studies The reason whyfor the fact that is the lack of theory supporting the causation between thefinancial ratios and bankruptcy All demonstrations are empirical such asJones (1987) and several others (Karels & Prakash, 1987; Lam, 1994; Wilson

& Sharda, 1994)

Talking about this issue, Wilson & Sharda (1994) say that the maindevelopment of bankruptcy model has intimately involved in economicvariables selection that increases predictive result For Jones (1987), it isreally considerable in view of the fact that many studies using various

techniques have produced the same ratios Pinches, Mingo & Caruthers(1973) specify some ratios including return on investment, capital turnover,financial leverage, short-term liquidity, cash position, inventory turnover andreceivables turnover These above factors, according to Jones (1987), mayplay an important role in economic interpretations.

On the other hand, a large number of researchers (Altman, Haldeman &Narayanan, 1977; Marais, Patell & Wolfson (1984); Foster, 1986) haveintroduced ratios concerning the financial market with the reason that theycontain essential information not derived from in financial statements

In the view of Zavgren (1983), a research with too many ratios may lead

to a problem of overfitting Contrary to this opinion, Wilson & Sharda (1994)state that the analysis result in Neural network method seem to be better withmore ratios compared to Multivariate Discriminant Analysis Similar toWilson & Sharda (1994), Udo (1993) find that a significant breakthrough incomputer today is of great advantage to model using many information

Karels & Prakash (1987) believe that selecting ratios in theaforementioned researches have not included the assumptions of MultivariateDiscriminant Analysis (MDA) This is the conclusion after conducting aresearch to examine ratios if whether they meet some assumptions enforced

by Multivariate Discriminant Analysis These researches apply some tests todetect normality among the selected ratios Although they do not entirelysatisfy the joint normality assumptions but their deviations are not the same asthose of other studies Comparing with Altman's 1968 study, in general, theirratios do improve prediction ability

Importantly, most of the ratios selected by Karels & Prakash (1987)match seven categories of Pinches et al (1973), having experimental

foundation They are working capital ratio, gross profit margin, earnings pershare, total debt to total assets, cash flow per share, market value of commonstock, asset turnover, sales per cash, and sales per receivables.

One of the important characteristic in relation to the life or the firm isprofitability (Lam 1994) The lower these ratios are, the higher the probability

of financial distress is

A kind of ratio being not less important is liquidity ratios They show theability of a company to satisfy its commitments without making an impact onoperations Lacking liquidity seems probable that firms may not pay their debt

on time (Lam, 1994) The working capital ratio is the liquidity ratio that will

be lower when firms experience financial distress

To leverage ratios such as total debt to total assets, they are higher forcompanies in unhealthy state (Somerville, 1989) In operations, economicalenvironments regarding the financial crisis, the intense competition or wildfluctuations in interest rate have high effects on payment of the company.Hence, levels of leverage are one of indispensable factors in model

Karels & Prakash (1987) assert that when firm’s financial status isunstable, it will definitely experience cashflow problems Cash flow ratios can

be used as an indication of which the companies’ ability generates future cashflows Moreover, the indirect relationship between cash flow and the long-term sustainability of dividend payout is remarkable A popular signal that themanagements do not take a sanguine view of whether future cash flows beardividends is the dividend cut (Somerville, 1989; Lau, 1987)

The activity ratios such as asset turnover, sales per cash, and sales perreceivables are of interest to researches (Zavgren, 1985; Somerville, 1989)contribute that the ratios as such have long run meaning that they are often

lower for companies in the distress state Sales per receivables is used to gauge the probability of the company recovering its debt.

Foster (1986) choose the market price of shares as an important indicator

of bankruptcy, although it is not a ratio The reason is that the financialstatements sometimes do not contain the necessary information comparedwith the market Karels & Prakash (1987) come to the conclusion that thepossibility of financial statements in anticipating the probability ofbankruptcy is not as good as the market

2.3 Techniques used in financial distress predictions

A variety of estimation techniques have performed in the academicliterature to build the prediction model One of the pioneering researches isBeaver (1966) who apply univariate method to capture the complexity ofbusiness This method, however, is said to be unsuitable for measuring acompany’s financial state as its construction is too simplistic (Foster, 1986;Jones, 1987; Lam, 1994) In spite of this, his study becomes a source ofinspiration for later researches

First, Altman (1968) develops Beaver’s (1966) issue by utilizing adiscriminant function with ratios in a multivariate analysis From then, MDA

is a popular technique used in distress predictions since it improves therestriction of univariate analysis MDA reveals the multidimensional side ofcompany and not resulting in conflicting signal while univariate method does.Nevertheless, MDA still remains two limited assumptions, which areoften violated (Foster, 1986; Jones, 1987; Lam, 1994) First, it makes mention

of that the variables must be multivariate normally distributed Second, thecovariance matrices of predictors for companies must be the same To resolvethis problem, Jones (1987) use log transformation, square root transformation

and elimination of outliers to improve the first assumption After that, he applies quadratic discriminant analysis to resolve the second assumption.

In fact, there are still opposite idea of the analysis According to Altman,Haldeman & Narayanan (1977), the quadratic model is more sensitive to thederivation sample and its classification is not good in the holdout sample.Moreover, the performance of the validity test does not accord with theory,although quadratic structure is supposed to be appropriate based on thestatistical data (Jones, 1987) He believes that making a few adjustments tothe theory of MDA technique does not increase its classification accuracy.Udo (1993) introduces some another problems with MDA such as the effect

of autocorrelation or the fact that this techniques does not include error in dataand control missing values as well

Heine (1995) declares that the accuracy rate of model using MDA from

1968 to 1995, specifically Altman (1968) Z score, achieves not less thaneighty to ninety percent However, Ohlson (1980) and Karels & Prakash(1987) add that the prediction probabilities are reliable only if statisticalassumptions are not complied in any case

One another statistical analysis discussed here is logit analysis Itoriginated from the logistic cumulative probability function The modelincludes a critical probability level to exam the classification and predictionaccuracy When a company reaches over this critical value, the likelihood isthat it is insolvency

This method does not incorporate the restrictive assumptions of MDA,however it contains the assumption that the costs of making type I error(classifying a bankrupt company as non - bankruptcy) and type II error(classifying a non - bankruptcy company as bankrupt) errors are equal Inaddition, it assumes that once the changes of the independent variables occur,midranges of probabilities are likely more sensitive than the extremes

Being different from MDA, logit analysis is not easy to correct for priorprobabilities A technique, called the Weighted Exogenous Sample MaximumLikelihood (WESML), is applied for the purpose of correcting it(Zmijewski,1984) Tests using WESML have the benefit of removing mostbias associated with the assumption that type I and type II errors are equal Incase of not making any correction, the methods will produce the wrongprobability unless the proportions between failing and stable firms in wholepopulation and those in the sample are not different (Jones, 1987) Adjustingthe cutoff score is the method to correct costs of misclassification, explainingthe disparity between type I and type II errors (Jones, 1987).

Comparing two techniques reveals that neither MDA nor Logit analysisprovides substantially better results (Wilson & Sharda, 1994) Tam & Kiang(1992) do not come to the conclusion which technique performs better On thecontrary, Somerville (1989) indicates that Logit Analysis seems to achievebetter results than MDA Similarly, Hamer (1983) compares Logit with MDAand decides that the outcome with the logit analysis may be slightly moreprecise than this with MDA

Ohlson (1980) states that logit model succeeds in dealing with theweakness of MDA to predict company failure Through nine independentvariables based on theoretical selection, Ohlson estimates the probability offailure for each industrial firm from the period 1970-1976 that has traded on a

US stock exchange at least 3 years With 105 failed firms and 2000 non failed firms, three models are set up: the first to predict failure within 1 year,the second to predict failure within 2 years and the third to predict failure in 1

-or 2 years The probability of failure f-or the firms in each model is calculated

by the logistic function

Jones (1987) evaluates that Logit analysis models is favorite comparedwith MDA because of the reason why the theoretical improvements formsolid basis for evaluating results Harrell and Lee (1985) say that a Logitmodel is still efficient, though all the assumptions of MDA exist

One more approach discussed here is that of Artificial Neural Networks(ANN) There are many researches illustrating the preeminent of the ANNamong other methods in predicting financial distress (Charitou and Kaourou,(2000); Tan and Dihardjo, 2001) Nevertheless, the fact that ANN does notreveal how the network groups the failing and non-failing company put it at

a distinct disadvantage called “black box” problem (Hawley, Johnson andRaina, 1990) One more drawback of ANN is that it does not make acontribution towards each variable in the final classification, i.e the variable’ssignificant

2.4 Hypotheses

As mentioned above, the thesis’ purpose is to elucidate the relationshipbetween financial ratios and financial distress of listed companies in VietNam However, Viet Nam Stock Exchange has just been set up over 12 years

It has been considered as a “young market” One more problem is consideredwhether these connections are consistent with earlier researches

Thus, some hypotheses to be tested will be introduced in this thesis:

- H1: Earnings per share impacts negatively on the probability of failure.

- H2: Cash flow per share impacts negatively on the probability of failure.

- H3: Asset turnover impacts negatively on the probability of failure.

- H4: Sales per receivables is negatively impacting on the probability

- H7: Gross profit margin is negatively impacting on the probability

on the models of Altman (1968) and Ohlson (1980) (Boritz et al 2007).However, logistic regression analysis is more and more popular in the vastmajority of international failure prediction studies (Barniv, 2002; Charitou,2004; Mohamad, 2005; Chen, 2008)

By means of the logistic regression technique’s advantage, this studyaims to research the financial ratios’ impact on the financial distress amonglisted companies in Viet Nam