Corporate financial distress models a comparison of the two approaches

MINISTRY OF EDUCATION & TRAINING HO CHI MINH CITY OPEN UNIVERSITY - TRAN HONG VU CORPORATE FINANCIAL DISTRESS MODELS: A COMPARISON OF THE TWO APPROACHES MASTER THESIS FINANCE AND BANKING Ho Chi Minh City - 2018 MINISTRY OF EDUCATION & TRAINING HO CHI MINH CITY OPEN UNIVERSITY - TRAN HONG VU CORPORATE FINANCIAL DISTRESS MODELS: A COMPARISON OF THE TWO APPROACHES Major: Finance and Banking Major code: 60 34 02 01 MASTER THESIS FINANCE AND BANKING Academic Supervisor: Dr Vo Hong Duc Ho Chi Minh City - 2018 DECLARATION I, Tran Hong Vu, declare that the research work reported in this dissertation is my own It is submitted to fulfill the requirements for the Masters of Finance and Banking degree at the Open University of Ho Chi Minh City This thesis has not, either in whole or in part, been submitted for a degree or diploma to any other institution or university for a similar qualification except where otherwise indicated and acknowledged There are no other research papers used in this dissertation that are not cited in accordance with regulations This thesis has never been submitted to receive any degree at other universities or training institutions HCMC, March 2018 i ACKNOWLEDGEMENT Firsts of all, I would like to thank all the lecturers of Graduate School of Ho Chi Minh City Open University that I have learned The knowledge I have gained is the fundamental foundation for me to complete this dissertation Next, I would like to express my sincere gratitude to my advisor Dr Vo Hong Duc for the continuous support of my Master thesis, for his patience, motivation, and immense knowledge His guidance helped me in the time of writing research proposal and my thesis I feel lucky thanks to having a devoted support and direction of my advisor for my thesis I would like to thank my classmates for accompanying me throughout the school year as well as during my dissertation Your comments, encouragement and sharing knowledge together helped me gain more confidence and motivation to complete this thesis Thank you to the members of the Business and Economics Research Group of Ho Chi Minh City Open University assisting me in the process of doing the thesis Finally, I would like to express my sincere thanks to my family, my beloved ones for supporting me and during my study and dissertation In memory of my father… ii ABSTRACT The research was conducted to provide empirical evidence for comparing the differences in measuring and determinants affecting financial distress level of firms using two models: accounting-based model (Z-Score) and market-based model (KMV Distance to default) Throughout history in the field of credit risk research, many models have been developed by researchers in measuring and predicting financial distress or bankruptcy The tested of research hypotheses are based on a sample of 631 non-financial listed firms in the Vietnamese Stock Market (Hochiminh City Stock Exchange - HOSE - and Hanoi Stock Exchange - HNX) in the period from 2006 to 2016, in which the crisis period is from 2008 to 2012 The result showed that Asset-liabilities ratio, Rate of return on total assets, Retained earnings to total assets ratio affect firm's financial distress In particular, Asset-liability ratio and Retained earnings to total assets ratio are proportional to financial distress, Rate of return on total assets ratio is inversely proportional to financial distress The computed result of the financial distress level of two models (accountingbased and market-based models) is differences because of the differences in the basis of input information used Industrials and Health Care sectors were warned to be the highest risk of falling into financial distress sectors among the rest sectors The differences in the results of the two models also showed the information transparency and the herding behavior problems in the market In the economic recession of Vietnam due to the impact of the global financial crisis (2008 to 2012), both two models showed that the financial distress level was higher than the other periods The findings of this study provide empirical evidence for measuring and predicting the financial distress of listed firms in the context of the Vietnamese stock market This result can be considered as a necessary reference for companies to improve their risk management operations, especially in loan decisions to avoid having difficulty solvency In addition, authorities and market regulators can use these findings to formulate effective management policies for companied, thereby boosting market development, creating a safe investment environment for investors Investors can also refer to the research results to learn more about the sectors before making investing decision Furthermore, the research will be a stepping stone and encourage researchers to pay iii more attention to the field of forecasting financial distress Once a company falls into financial distress, bankruptcy is only a matter of time Therefore, the forecast of financial distress is very important in firm operations, it is the first step to help company avoid bankruptcy iv TABLE OF CONTENTS CHAPTER 1: INTRODUCTION 1.1 Research topic 1.2 Research Objectives 1.3 Research Questions 1.4 Research object and scope 1.5 Research Contribution 1.6 Research Structure CHAPTER 2: LITERATER REVIEW 2.1 Corporate financial distress 2.2 Financial distress and bankruptcy 2.3 Models of corporate financial distress 2.3.1 Accounting – based models 10 2.3.2 Market – based models 17 2.4 Previous empirical studies .21 2.4.1 Accounting – based models 21 2.4.2 Market – based models 23 2.4.3 Comparison of accounting – based and market – based models 24 CHAPTER 3: METHODOLOGY AND RESEARCH DESIGN 28 3.1 Data 28 3.2 Selection of models 32 3.2.1 Accounting-based model (ZChina-Score model) .32 3.2.2 Market-based model (DD model) 38 3.3 Hypotheses .38 CHAPTER 4: RESEARCH RESULT AND DISCUSSION .40 4.1 Research result 40 4.1.1 Variables description .40 4.1.2 Empirical result 42 v 4.2 Discussion 48 4.2.1 Empirical result of regression model 48 4.2.2 Z-score and Distance to Default 51 CHAPTER 5: CONCLUSIONS 63 5.1 Research conclusion 63 5.2 Policy Implications 64 5.2.1 For the Vietnamese government 64 5.2.2 For enterprises 65 5.2.3 For investor 67 5.3 Limitations and further research 67 REFERENCE 69 vi ABBREVIATIONS ASEAN : Association of South-East Asian Nations CDD : Conditional distance to default DD : Distance to default EBIT : Earnings before interest and tax EBITDA : Earnings before interest, tax, depreciation, and amortization MDA : Multiple discriminant analysis EDF : Expected default frequency EM : Emerging market GDP : Gross domestic product GFC : Global financial crisis HNX : Hanoi Stock Exchange HOSE : Hochiminh City Stock Exchange ICR : Interest coverage ratio RETA : Retained earnings to total assets ratio ROA : Rate of return on total assets TLTA : Asset-liability ratio (total liabilities/total assets) VIF : The variance inflation factor WCTA : Working capital to total assets ratio WTO : World Trade Organization vii LIST OF FIGURES Figure 3.1 Annual Vietnam's GDP growth 31 Figure 4.1: Vietnam Industrial Production Index 54 Figure 4.2: The total number of enterprises adjust profit after auditing over years 60 viii profits in their financial statements, Utilities, Real Estate and Consumer Discretionary are highly appreciated by the DD model reflecting the fact that the stock prices of these companies are very hot in the market It is noteworthy that the Health Care industry has performed well due to the characteristics of the industry as analyzed above, but also because of these characteristics that the stock price is less volatile Therefore, the results of this industry are contradictory when put into ZScore and DD models While Z-Score model highly estimated the industry with accounting-based inputs, DD model underestimated with market-based inputs This shows that accounting information (measured by Z-Score) does not fully and transparently reflect market movements (through stock prices - measured by the DD model) At present, information transparency of listed companies is still limited Firms have different tricks on financial statement to make a "nice" information attracting investors to achieve investment goals According to statistics from 2012 to the first months of 2015, each year the proportion of listed companies adjusted profit after auditing is above 70%, the first half of 2015 also accounted for over 52% Figure 4.2: The total number of enterprises adjust profit after auditing over years 800 90% 82% 700 77% 625 609 679 643 80% 72% 600 70% 60% 500 52% 400 300 300 280 219 40% 263 30% 214 198 179 200 50% 138 100 20% 10% 0% 2012 2013 Total 2014 Decreased Increased 6M2015 % Source: vietstock.vn2 https://vietstock.vn/2015/10/lien-tuc-chenh-lech-sau-kiem-toan-doanh-nghiep-dang-ve-gi-737-441594.htm 60 Several studies have provided scientific evidence on information transparency issues such as Nguyen Tien Hung (2016), Nguyen Tran Nguyen Tran (2014) This can be beneficial to the business in the short term but in the long term will cause more risks for businesses and investors In addition, Vietnam's stock market is currently considered an emerging market, consisting mostly of individual investors (more than 99% of the total number of investors in the market, according to Vietnam Securities Depository - VSD in 2016) Most individual investors tend to have less professional knowledge and cannot access information accurately and easily These investors rarely use financial statement information (fundamental analysis) when making investment decisions because of time constraints and costly collection, evaluation information Hence, they will usually invest in trend of crowds, follow the action of others, also known as herding behavior These actions cause fluctuations in the market The above problems make the difference between the calculated results of the Z-Score and Distance to Default In addition, during the Vietnam economic crisis (2008-2012), both Z-Score model and DD model showed the decreasing in average score of each sector but in two different trends At this stage, firms are facing many difficulties and losses in operation, so the Z-score model shows a downtrend As for the DD model, the downtrend only occurred during the first three years of the crisis period (2008-2010) and then partially recovered in 2011 and 2012, thanks to the recovery efforts for stock market In brief, Chapter presented and analyzed descriptive statistics, matrix correlation coefficients, selected appropriate regression models, and tested regression assumptions for the selected model Then, the test of the hypotheses set forth in Chapter is performed The research gave analysis and argument to explain the relationship between independent variables and dependent variables As a result of the regression model selected, three of four independent variables were able to explain the financial distress ability: Asset-liability ratio (TLTA), Rate of return on total assets (ROA), Retained earnings to total assets ratio (RETA) Whereas Asset61 liability ratio and Retained earnings to total assets ratio are proportional to financial distress and Rate of return on total assets is inversely proportional to financial distress Chapter also calculates Z-score and Distance to Default to look at the ability to measure financial distress of two models with two different groups of inputs: accounting information and market information 62 CHAPTER 5: CONCLUSIONS Chapter detailed and discussed the results of the study about two approaches predicting financial distress in the context of Vietnamese stock market Chapter will summarize the achievement of this study and provide implications and recommendations for the results of the study In addition, the limitations of the study will be discussed in order to propose some directions for further research in this sector 5.1 Research conclusion With a sample of 631 listed firms in the Vietnamese stock market over 10 years from 2006 to 2016 and divided into 10 major sectors, the results of Chapter solved the objectives set out in Chapter 1: (i) Three of the four determinants of the Z-score model which Altman made for the Chinese stock market were able to explain financial distress prediction for listed firms in the context of Vietnam These are:  Asset-liability ratio is proportional to financial distress;  Rate of return on total assets ratio is inversely proportional to financial distress;  Retained earnings to total assets ratio is proportional to financial distress;  There is no evidence of a relationship between working capital to total asset ratio and financial distress (ii) There are differences between the Z-score and Distance to Default forecasting the financial distress of listed firms Z-score showed that Industrials has the highest risk while Health Care is warned by Distance to Default (iii) In the Vietnamese economic crisis (2008-2012), both models alerted the increase of the financial distress level but expressed through two different trends While the Z-score showed that financial distress levels increased 63 during over crisis period, Distance to Default showed only an increase in the warning level in 2008 and 2010, then the safety of the financial distress level increased in the remaining year of crisis period 5.2 Policy Implications In Vietnam, the risk management, especially the credit risk of Vietnamese enterprises has made positive changes in recent years but still reveals many limitations Specifically, the identification of risk is still formal and very few enterprises focus on risk management The number of enterprises using quantitative methods to measure risk is small Most of the solutions that firms offer are more risktaking than risk prevention and control This is an alarming issue, reflecting the high level of non-peforming loans (NPLs) of the entire banking system, the large number of firm bankruptcy every year On the basis of the empirical results, this study contributes scientific evidence in the form of recommendations with the desire to provide useful reference for the relevant subjects: 5.2.1 For the Vietnamese government In recent years, the control of credit risk has always been paid special attention by the Government, especially in the context of the NPLs level in the entire banking system is very high The State Bank of Vietnam have been continuously issuing policies to strengthen control credit granting activities at commercial banks, princibally requiring credit institutions to control the risk of extending credit, grant credit for customers with large loans In addition to extending credit to customers, it is necessary to ensure credit growth according to annual targets; focus on credit in the fields of production and business, priority areas under the Government's direction, limiting credit extension beyond the risky areas Authorities should also have policies to enhance transparency of corporate financial information as well as to reduce the stock market behavior of investors as follow: (i) fully applying International Financial Reporting Standards (IFRS) and relevant interpretations for public corporations The World Bank’s Reports on the Observance of Standards and Codes (ROSC) in accounting 64 and auditing sector indicated that the quality of financial statement of public corporations in Vietnam has only been partially applied to IFRS and is currently inconsistent with international practice (The World Bank, 2013); (ii) increasing the sanctions for violations of the accounting and financial statement reporting At present, the administrative sanction level in the accounting sector is only VND 30 million (according to Decree No 105/2013/ND-CP stipulating the sanctioning of administrative violations in the domain of accountancy with effect from 01/12/2013) The fine is still relatively low compared to the profitability data that enterprises are willing to hide to avoid the obligation to pay corporate income tax; (iii) continue improving the legal basis for the Vietnamese stock market in accordance with the standards of the International Organization of Securities Commissions (IOSCO), especially for disclosure of listed companies; (iv) increasing the professionalism of individual investors and encourage the development of institutional investors Accordingly, measures should be taken to improve the understanding of individual investors in the use of fundamental analysis when making investment decisions Investors need to identify and insist on the investment objective that corresponds to their risk tolerance, avoiding blind action under market rumors In addition, it is necessary to develop professional institutional investors such as closedend funds, open-end funds, retirement funds, etc Many studies in the world have shown that a stable and developed market is indispensable to investors With the professional valuation process and strict investment discipline, institutional investors will help make the market more efficient 5.2.2 For enterprises The research results provided scientific evidence for listed firms when building corporate governance mechanisms Companies need to have a more critical view of corporate risk management, especially credit risk Listed companies should refer to 65 the results of this research so that they can be applied appropriately when developing a flexible, dynamic and effective corporate governance mechanism Specifically: (i) Enterprises should focus on disseminating and propagandizing policies, raising the level of risk management to all members from the Board of Directors to employees in the enterprise Businesses also need to rearrange personnel and assign clear powers and responsibilities between the Chief Financial Officer (CFO) and the Chief Risk Officer (CRO); strengthening the internal control system within the enterprise as well as allocating reasonable funds for risk management activities; (ii) Enterprises should consider using appropriate financial leverage A tolerable level of debt will help companies take advantage of the tax shield, thereby increasing profits However, if the enterprise borrows too much debt, it will negatively affect the enterprises with solvency problems; (iii) Company profit is always the target that managers in the business direction In addition, corporate managers need to pay attention to asset efficiency so that businesses achieve positive Rate of return on total assets ratio (ROA), which limits their ability to fall into financial distress Avoiding the company operation is profitable, but the scale of its assets increases too high (such as expanding factory investments that increase fixed assets, over-production of products increasing inventories, etc.) making an ineffective ROA; (iv) The distribution of dividends to shareholders and the retained earnings of the company should also be noted Managers and shareholders of the company should agree on the appropriate rate of dividends, as well as the retained earnings to reinvest The proper dividend payment also helps the firm avoid the problem of agency costs; (v) Besides that, corporates need to develop an effective accounting system Company managers need to improve their accountability and compliance with the law on disclosure of information and financial statement The 66 accounting staff of the enterprise must have professional capacity, regularly update the accounting standards in accordance with the law 5.2.3 For investor The results of the study showed the forecasts of the possible financial distress of industries Investors, especially individual investors should carefully study the stock of enterprises in the investment sector, carefully review the information as well as financial statement of enterprises to have official information sources Thus they can make investment decisions that fit the investor's goals, avoiding the crowd trend in the market In parallel, investors should also be aware of signs of fraud in company’s financial statement 5.3 Limitations and further research The study has provided empirical evidence for predicting the ability and the determinants that affect the corporate's financial distress However, due to the limitations of time and ability, research still has certain limitations From there, further research can be done to improve this field: Firstly, market indicators (in addition to the accounting indicators that have been made in the study) can be included to find out the factors that affect the company's financial distress Secondly, because the KMV model is a copyrighted model owned by Moody's Accordingly, Distance to Default will continue to be modeled deeper and result in Probability to Default (PD) and the Expected Default Frequency (EDF), which then can be classified and ranked next to the company with the Z-Score scale Further research can be done in this 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Retrieved December 30, 2017, from https://vietstock.vn/2015/10/lien-tucchenh-lech-sau-kiem-toan-doanh-nghiep-dang-ve-gi-737-441594.htm Thanh Thanh Lan (2013) Tang truong GDP 2012 thap hon bao cao Retrieved December 30, 2017, from https://kinhdoanh.vnexpress.net/tin-tuc/vi-mo/tangtruong-gdp-2012-thap-hon-bao-cao-2749051.html 74 ...  Corporate financial distress  Financial distress and bankruptcy  Models of Corporate Financial Distress  Previous Empirical studies 2.1 Corporate financial distress The term ? ?financial distress? ??... predictor of financial distress However, the comparison of the predictive accuracy of the logit model with multivariate discriminant analysis by means of the same set of variables and the same sample... implications of the national and international legal proceedings on the capital structure of the firm The most important signals about financial distress can be received from the analysis of financial