Determinants of financial distress, a study of listed companies in vietnam

--- DETERMINANTS OF FINANCIAL DISTRESS: A STUDY OF LISTED COMPANIES IN VIET NAM ECONOMICS MASTER THESIS Major: Business Administration Ho Chi Minh City - 2012... UNIVERSITY OF ECONOMI

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

ECONOMICS MASTER THESIS

Major: Business Administration

Ho Chi Minh City - 2012

UNIVERSITY OF ECONOMICS HO CHI MINH CITY

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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 set financial ratios and the probability of failure companies Through the Logistic regression method, the results show that EPS, Cash per shares and Asset turnover are the most important financial ratios, which help investors to identify the financial distress of listed companies in Vietnam Stock Exchange

ACKNOWLEGEMENTS

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

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

Last but not least, my thesis would be nothing without the enthusiasm and 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 for special references, quotations and summaries All data, references using in this research are clearly identified The thesis has not been accepted for any degree 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 location for the trading activities of medium and long – term securities The market participants including individual and institutional investors such as the mutual funds and the insurance companies perform the purchases and sale of stock for many different purposes involved in a good profit or taking over the control of the enterprise However, the most benefit from the establishment of stock 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 after the first one, New York Stock Exchange (NYSE), and contributed significantly to the national economies

With the awareness of the stock market’s important role, the Securities Trading Center in Ho Chi Minh City, now called Ho Chi Minh City Stock Exchange (HOSE), was established under the Decision No 127/1998/QD-TTg dated 11/07/1998 and formally put into operation on 28/07/2000 with only two listed companies From now on HOSE has many remarkable achievements For example, until 31/12/2007, there were about 507 listed companies with a total market value of 365 trillion, 3 securities investment funds 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 of Vietnamese 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 to financial difficulties Under the major impact of the economic crisis, the total profit 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 the market participants such as shareholders, creditors, managers, especially individual investors How do these investors protect them from this bad damage? Through many researches, one conclusion is declared that firms in the financially distress state have some particular characteristics relevant to losses, a high leverage, low and volatile stock returns, etc Recognizing these signs is a way for warning not only investors but also enterprises in operation

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

However, the two most popular methods are Multiple Discriminant Analysis and Logistic regression These techniques combined with a set of financial ratios come up with the most famous two models, Altman’s Z score model (Altman 1968) and Ohlson’s model (Ohlson 1980) The research by Beaver (1966) and Altman (1968) focus on the main problem that is the predictable ability of model developed from financial ratios Based on this classic research, the Z score model have been developed carefully through further studies of some researchers including Deakin (1972), Taffler ( 1985 ), Goudie (1987), Grice and Ingram (2001), Agarwal and Taffler (2007), and Sandin and Porporato (2007)

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

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

of falling into financial distress, some preventive methods may be implemented For example, they can reject loan applications or borrowers must take more steps aiming to avoiding loan defaults before receiving money

So which technique is the precise one? That is the argumentative question Each of them has its own advantages and disadvantages The effectiveness of the methods might be high or low at different times The reason 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 their behaviors is not as exact as predicting one person’s behaviors Results from each research also depend on other factors such as the characteristics of each stock market, time for collecting data, etc

For a long time, applying these techniques in predicting financial distress to Vietnam Stock Exchange is still not much while many publicly listed companies have fallen in to this stage As a result, it is worthy to provide a research aiming to investigate the role of financial ratios in predicting 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 to clarify the relationship between financial ratios and the financially distress of listed 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 introduce the 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 the final 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 researches regarding financial distress Dun and Bradstreet (1985) clarify the financial distress as the discontinuity of the business operation To Foster (1986), a company is in financial distress when it has serious liquidity problems settled through crucial changes in entity’s operation Liquidity problem is known as a state where all company’s current obligations can not be strictly enforced There also have been definitions of financial distress like reduction of dividend and defaults on debt

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

In general, “financial distress” is a term indicated a condition when commitments to creditors of a company are broken or in difficulty Sometimes financial distress can lead to insolvency Thus, it requires each government in every country to issue some regulations on dealing with financial distress in the corporate sector That is one of the reason why there are quite much discussions defining failure legalistically This kind of definition has a dominant advantage that it provides researches criterion to easily 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 accordance with some regulations in Insolvency Act of 1986 They are five courses of action: administration, company voluntary arrangement, receivership, liquidation and dissolution

In Viet Nam, according to the Law on the Bankruptcy of the National Assembly released dated 15 June 2004, a company is filed for bankruptcy because of not being able to pay the debt when it is due However, this company still has a chance to recover its operation prior to the time when the High Court declares bankruptcy All creditors organize a Conference to appraise, adjust the company’s rehabilitation plan for production and payment 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 the production 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 firm declared a state of bankruptcy in the High Court One of the main reasons is that the administrative procedure regardless of bankruptcy is quite complicated and collecting information relating these companies are very difficult The public listed companies in the Ho Chi Minh Stock Exchange, during over fifteen–year operation, have not been obliged to file for bankruptcy, although some of them stay into the pessimistic financial situation

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

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

Some underlying conditions of classification pursuant to the law for each case 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 higher than 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 being warned

 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 or certificates 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 listed company has negative earnings for three consecutive years and the total 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 trading when 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 financial difficulties of companies is the most appropriate approach because of the ability to use regularities in the relationship between the ratio and an event of interest Ratio models are derived from financial statements whose ratios differ from stable and unstable firms However, performing financial ratios need to pay more attention because of the interpretation of accounting standards as a base for financial reports

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

& Sharda, 1994)

Talking about this issue, Wilson & Sharda (1994) say that the main development of bankruptcy model has intimately involved in economic variables selection that increases predictive result For Jones (1987), it is really 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 and receivables turnover These above factors, according to Jones (1987), may play 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) have introduced ratios concerning the financial market with the reason that they contain 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 with more ratios compared to Multivariate Discriminant Analysis Similar to Wilson & Sharda (1994), Udo (1993) find that a significant breakthrough in computer today is of great advantage to model using many information

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

by Multivariate Discriminant Analysis These researches apply some tests to detect normality among the selected ratios Although they do not entirely satisfy the joint normality assumptions but their deviations are not the same as those of other studies Comparing with Altman's 1968 study, in general, their ratios 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 per share, total debt to total assets, cash flow per share, market value of common stock, asset turnover, sales per cash, and sales per receivables

One of the important characteristic in relation to the life or the firm is profitability (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 the ability of a company to satisfy its commitments without making an impact on operations 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 for companies in unhealthy state (Somerville, 1989) In operations, economical environments regarding the financial crisis, the intense competition or wild fluctuations 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 is unstable, it will definitely experience cashflow problems Cash flow ratios can

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

The activity ratios such as asset turnover, sales per cash, and sales per receivables 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 financial statements sometimes do not contain the necessary information compared with the market Karels & Prakash (1987) come to the conclusion that the possibility of financial statements in anticipating the probability of bankruptcy is not as good as the market

2.3 Techniques used in financial distress predictions

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

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

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

of that the variables must be multivariate normally distributed Second, the covariance matrices of predictors for companies must be the same To resolve this 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 the derivation 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 the statistical data (Jones, 1987) He believes that making a few adjustments to the 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 data and 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 than eighty to ninety percent However, Ohlson (1980) and Karels & Prakash (1987) add that the prediction probabilities are reliable only if statistical assumptions are not complied in any case

One another statistical analysis discussed here is logit analysis It originated from the logistic cumulative probability function The model includes a critical probability level to exam the classification and prediction accuracy When a company reaches over this critical value, the likelihood is that 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 In addition, 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 prior probabilities A technique, called the Weighted Exogenous Sample Maximum Likelihood (WESML), is applied for the purpose of correcting it (Zmijewski,1984) Tests using WESML have the benefit of removing most bias associated with the assumption that type I and type II errors are equal In case of not making any correction, the methods will produce the wrong probability unless the proportions between failing and stable firms in whole population and those in the sample are not different (Jones, 1987) Adjusting the cutoff score is the method to correct costs of misclassification, explaining the disparity between type I and type II errors (Jones, 1987)

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

Ohlson (1980) states that logit model succeeds in dealing with the weakness of MDA to predict company failure Through nine independent variables based on theoretical selection, Ohlson estimates the probability of failure 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 for the firms in each model is calculated

by the logistic function

Jones (1987) evaluates that Logit analysis models is favorite compared with MDA because of the reason why the theoretical improvements form solid basis for evaluating results Harrell and Lee (1985) say that a Logit model 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 ANN among other methods in predicting financial distress (Charitou and Kaourou,(2000); Tan and Dihardjo, 2001) Nevertheless, the fact that ANN does not reveal how the network groups the failing and non-failing company put it at a distinct disadvantage called “black box” problem (Hawley, Johnson and Raina, 1990) One more drawback of ANN is that it does not make a contribution towards each variable in the final classification, i.e the variable’s significant

2.4 Hypotheses

As mentioned above, the thesis’ purpose is to elucidate the relationship between financial ratios and financial distress of listed companies in Viet Nam 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 considered whether 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 vast majority of international failure prediction studies (Barniv, 2002; Charitou, 2004; Mohamad, 2005; Chen, 2008)

By means of the logistic regression technique’s advantage, this study aims to research the financial ratios’ impact on the financial distress among listed companies in Viet Nam