How Do Financially Distressed Companies Overcome Decline Economics Essay

How Do Financi bothy Distressed Companies Overcome Decline Economics EssayThe break paper analyzes the recuperation work at of 526 US firms veneer an sign fiscal harm spatial relation in rule to determine the variables of influence on their last(a) survival status. The proposed pretense of this recovery process implies that acrimony and reply capability should be understood as sign conditions that will impose restrictions in the selection of st vagabondgies which will shoot for the capital punishment during recovery, thus, determining the utmost small town of long term financial agony process. We effectuate that these variables live an invasion on i) the ability of a corporation to overcome decline ii) the efficiency of the selected strategies and iii) the results of these strategies on post-distress fit position.Keywords Recovery process, financial distress, severity, Data Envelopment AnalysisIntroductionEvery organization is inevitably receptive to ups and d owns during its lifecycle (Krueger and Willard, 1991 Burbank, 2005) and failure is non a sudden event (Agarwal and Taffler, 2008). The ecological theory of organizations states that in a continuous process of firms, those who survive argon better competent to compete. Kahl (2001) defines fittest firms as the ones that have greater chance to survive. In this way, the financial distress process should be understood as a selection mechanism by means of which good performers survive and bad performers do non. In this same line, Sheppard and Chowdhury (2005) consider that failure is a firms misalignment with its environment.Failure is a reversible process and not necessarily degenerative if the company is able to detect signs of under effect and to achieve an effort in its economic performance. Firms facing a distressed financial maculation comm all share a serial publication of common patterns which make it difficult to estimate a achievable outcome of this situation (Barniv et al ., 2002). Among the distressed firms, there are slender divergences in the financial weakness indicators in the different failure processes (Ooghe and Prijcker, 2008). The dissimilarities between the failure stages and the turnaround strength as well, become evident on the how promptly the indicators evolve and on the ability of the focus to react when distress signals are detected. Ignoring these alert signals whitethorn lead to a continuous decline process which whitethorn end up in failure without even trying any recovery strategy (Burbank, 2005).Managing a crisis situation is a fundamental issue as it is not a spontaneous process. Moulton and Thomas (1993) rove that the reorganizations during a financial distress situation are not a simple matter and the probability of a victorious exit is very low. However, the percentage of firms that succeed in getting done decline cannot be disregarded. Barniv et al. (2002) found that 50% of the sample firms which filed nonstarter from the Office of the General Council of SEC re gaind their situation as emerged firms. One third of the financially distressed firms in Kahls (2001) study survived as in leechlike companies. Moreover, Gonzlez-Bravo and Mecaj (2011) found that 22.5% of sample firms presenting a strong crisis situation were still active in the market 10 years later. Yet, we should consider that the exit from a difficult condition, as Moulton and Thomas (1993) sustain, is solo the beginning of the story. Not all the advantagefully exiting firms manage to keep the in the buff situation stable. For some firms, operating in a crisis situation constitutes their normal state of environment with crisis effects that can attenuate or loose up. Anyway, world able to maintain this kind of condition is too a demeanor to survive. In this sense, Kahl (2002) states that the financial distress should be considered a long term process that makes firms end up debilitated even after having recovered from decli ne. This weakness is observed in poor performance that inevitably may again drag the firms to a new financial distress situation. Hotchkiss (1995) attested that during the first vanadium years after exiting a bankruptcy, 35 to 40% of firms show electronegative operating income and up to one third of the firms that manage to ease their distress through debt restructuring re-enter a financial distress situation a few years later.Several studies have shown that different factors may determine the exit from a crisis situation. These factors may have a direct influence on the recovery process or on the capacity of the company to develop subdue direction strategies. The initial severity degree is considered an important hurdle in implementing roaring actions. In this line, smith and sculpture (2005) found that, among all variables of the study, severity and firm surface were the only variables significantly important during a turnaround process. Other authors (Robbins and Pearce, 1 992 Pearce and Robins, 1993 Harker and Harker, 1998) state that strategies oriented towards cost reduction and efficiency improvement were safe bets for a favorable outcome. However, Castrogiovani and Bruton (2000), Sudarsanam and Lai (2001) or Smith and Graves (2005) affirm that no positive relation could be found between sure strategies and successful outcome. These results indicate that severity, through its influence on the selected strategy, could be an indirect factor in the turnaround process (Robbins and Pearce, 1992).More consensual results were obtained when stating that the performance in-distress is fundamental for the outcome of the difficult situation. In particular, it is observed that successful companies show better returns when compared to unsuccessful firms (Routledge and Gadene, 2000 Pearce and Doh, 2002 Kahl, 2001).The present paper analyzes the recovery process of 526 US firms facing an initial financial distress situation in order to determine the variables o f influence on their final survival status. The proposed model of this recovery process states that severity and reaction capability should be understood as initial conditions that will impose restrictions in the selection of strategies which will drive the performance during recovery, thus, determining the final resolution of long term financial distress process. These variables have an impact on i) the ability of a company to overcome the difficult situation ii) the efficiency of the selected strategies and iii) the results of these strategies on post-distress healthy position. The proposed model considers that final survival status stairs the offbeat spirit of a firm based on its risk to re-enter in distress, so it discriminates well performers and silk hat performers during the management of a crisis process.Overcoming a financial distress Determinant factorsEven though some weak crisis situations tend to show a natural evolution throughout the exit and may be solved by sim ply making routine decisions (Gonzlez-Bravo and Mecaj, 2011), recovery process is not a spontaneous event. The distressed firms will face a long term scenario involving a continuous effort of adaptation to the diverse situations through which a firm passes during the upturn. The effort invested in this process will impart the reestablishment of stakeholders trust, while the variables related to solvency and profitability gain stability (Burbank, 2005). Companies that do not have a long term orientation and just adopt tinkers dam strategies do not usually r each(prenominal) successful exits (Pretorius, 2008). However, certain initial conditions may affect the reaction capacity as well as the effectiveness of the measures taken by managers.SeveritySimilar to a disease process, the gravity of the initial crisis position not only conditions the measures to take but also their success possibilities. Firms that face worse starting situation need to make greater efforts. In this sense, R obbins and Pearce (1992) affirm that there exists a relationship between retrenchment strategies and performance in firms having a severe starting situation while this relationship is not observed in firms facing a weak crisis state. Although Smith and Graves (2005) indicate that the gravity of the starting situation is strongly associated with the probability of recovery, Kahl (2002) sustains that the financial distress diagnosis is an imperfect indicator of the economic feasibility of a firm. In the same line, Gonzlez-Bravo and Mecaj (2011) affirm that the severity of the initial situation, observed in widely accepted indicators, does not have to be a crucial factor in the outcome of the crisis. Perhaps, following Moulton and Thomas (1993), the initial gravity status has an influence over the process of recovery to a greater extent than on the final resolution. Thus, severity determines the rate of recuperation, so that the harder the severity, the greater the effort to react and the slower the process of healing the take aims of solvency and profitability. This effort during the process, and not the starting situation, may be the main determinant of the final outcome. Moreover, solvency and profitability indicators such as continuous negative results, inability to generate income by means of operating military action, continuous solvency and/or liquidity problems or stupidity to generate cash flow which reflect problems in the health of the company, are widely accepted as measures of severity degree (Mutchler and Williams, 1990 Gilbert, Menon and Schwarz, 1990 Ponemon and Shick, 1991 Poston, Harmon and Gramlich, 1994 Geiger, Raghunandan and Rama, 1995 Raghunandan and Rama, 1995 Davydenko, 2007).Reaction capabilityThe possible effect of severity on the initial state may be mitigated if the firm counts on appropriate resources which increase the probability of a successful recovery. The structural reaction capability may ease the recovery process to a saf e position cushioning the possible actions to implement. The capacity to obtain redundant funds or generate additional incomes to implement treatment strategies can soothe the prior pressure imposed by a deteriorated financial distress position. In this sense, Barker and Duhaime (1997) associate successful turnaround processes with increases in sales that make companies have more options to undertake change strategies. Similarly, Pearce and Doh (2002) affirm that firms in distress that used debt and supported their sales to improve profitability successfully solved their difficult situation. They also state that changes in activity and in supplement level are associated with different phases of a turnaround process. In turn, Jostarndt (2006) identifies three factors which could be helpful to measure the risk of becoming financially troubled. An high-spirited leverage level, a poor firm performance, and an industry downturn may inhibit firms from obtaining the right amount of cash flow to operate normally. Firm operating performance trend dominates as the reason causing financial distress showing that a firm may fail but not only for financial reasons. This allows the author to consider an association between financial distress and economic distress. These results are comparable to the patterns evidenced by Gonzlez-Bravo and Mecaj (2011) when distressed firms with remarkable financial reaction capacity and/or a solid financial structure evolve mainly toward a healthy zone. However, concerning debt structure Kahl (2001) did not find evidence on if the debt level or the debt structure of a firm influences the final outcome of a crisis situation.Severity Status and Reaction Capability, as initial restrictions, could be moderated by firm size when considering the exit from a crisis situation (Moulton and Thomas, 1993 Barniv et al., 2002 Schutjens, 2002). Altman and Hotchkiss (2006) found that one of the most obvious factor that discriminates between firms that s uccessfully restructure and those that liquidate, after being classified inside Chapter 11, was the firms size. Nevertheless, other works observe that this variable did not present any clear relation with the survival chance (Kahl, 2001 Ooghe and Prijcker, 2008). Possibly, firms size does not determine the final resolution of a distress situation but it influences the reaction capability to confront it, moderating /strengthening the drawbacks when additional support should be guaranteed and restructuring decision must be made. execution of instrument in-distressRegardless of the initial state restrictions, the adopted strategies and the behavior of companies during a financial crisis are crucial for the exit process (Sun and Li, 2007). An inappropriate diagnosis of the firms weaknesses in order to act and react quickly may lead to a fast deterioration of the financial indicators (Barker and Duhaime, 1997). Beaver (1966) already verbalize that if a difficult situation was properly d etected, measures that lead to an improved position could be taken, avoiding so a state of ultimate failure. A series of strategies and action plans should be implemented aiming to reduce the detected weaknesses of the company (Smith and Graves, 2005 Krueger and Willard, 1991, Robbins and Pearce, 1992 Pearce and Robbins, 1993 Arogyaswamy et al., 1995 Castrogiovanni and Bruton, 2000, Pearce and Doh, 2002 and Pretorius, 2008).The operating performance during the recovery process drives a successful evolutionary route towards a new healthy scenario (Kahl, 2001 Routledge and Gadenne, 2000). Improving efficiency through some actions like cost cutting and/or as cook reduction is crucial in this sense, having a positive impact on firms performance despite the underlying weaknesses (Robbins and Pearce, 1992 Pearce and Robbins, 1993 Harker and Harker, 1998). Firms facing a distress situation and carrying out a retrenchment strategy are more likely to survive, even though the performance was statistically not greater than that of not retrenched firms (Castrogiovanni and Bruton, 2000). In this sense, Sudarsanam and Lai (2001) showed that the strategies applied by firms successfully recovering were not that different from the strategies applied by firms that did not recover. So, the implementation efficacy was the cause of these differences, even though more intensive restructuration was done by firms that could not redirect their situation.The effectiveness of efficiency oriented strategies is supported by the results showing that firms resolving a situation of financial distress are statistically more profitable than those who did not settle (Campbell, 1996 Routledge and Gadenne, 2000 Pearce and Doh, 2002). These authors found that operating efficiency was the only variable used in distinguishing successful turnarounds from unsuccessful ones that significantly persisted during the recovery process. Kahl (2001) also stated that, in-distress, operating performance has a s trong positive relation with the survival prospect. In particular, the author shows that an improvement in the standard deviation of ROA during a crisis period can increase the survival probability up to 0.62. In the same line, Gonzlez-Bravo and Mecaj (2011) found evidence that the companies positioned in a safety zone, starting from a situation of failure status, are characterized by a strong managerial action measured by ROA ratio, generating furthermore higher operating cash flow. However, other authors such as Barniv et al. (2002) or Laitinen (1993) found that the ROA coefficients were statistically not significant in predicting the outcome of a crisis situation.The post-distress statusThe main objective of a firm facing a distress situation is to heal the crisis state. Some researches, oriented to modeling the variables that influence a recovery process, identify the final stage of this process when a firm objectively exits a failure situation emerging as an independent firm, l eaving Chapter 11 classification or keeping a delimit period of positive income (Smith and Graves, 2006 Barniv et al., 2002 Altman and Hotchkiss, 2006 Kahl, 2001). However, the accomplishment of this objective should have one necessary quality condition. The new post-failure position should be achieved in suitable conditions that would permit an appropriate and continuous growth and performance rate.A financial distress process could place a firm in a weak position, even if it had managed to solve its difficulties, inciting a poor performance that inevitably makes it enter again in an emergency situation (Kahl, 2002). If a firm does not emerge profitably in the restructuring phase, in order to achieve a long term success, the probability of a successful exit process is very low (Burbank, 2005). In this sense, Hotchkiss (1995) showed that up to one third of the firms that relieve their conditions by means of debt restructuring tend to go into a financial distress situation few years afterwards. With regard to post-distress position, Robbins and Pearce (1992) affirm that industry indicator variations should be considered in order to better identify the good performers or the exceptional good performers during turnaround. Despite of the assessment of Altman and Hotchkiss (2006) stating that the firms overcoming a Chapter 11 situation perform below firms of the same industry that did not pass through that same situation, Kahl (2001) found that the post-distress operating performance of firms getting through a crisis situation is similar to the industry performance.The model of recoveryWhen a firm is facing a distress situation and considering all the above analyzed dimensions, severity and reaction capability should be understood as initial conditions that will impose restrictions in selecting the strategies which will drive the performance during recovery, thus, determining the final resolution of long term financial distress process as shown in Figure 1.(Figur e 1 here)The left side of the diagram gathers the initial determining factors to jump the recovery process, outlining the firms ability to improve its afterlife and overcome the difficult situation. Severity Status offers valuable information about the initial degree of gravity of a firms situation. This degree will condition the actions to be taken in a deteriorated situation and the possible outcome as well. Reaction Capability measures the firms capacity to expend such actions through i) the possibility to obtain further resources without worsening its position, ii) the capacity of debt negotiation or iii) the ability to generate additional incomes which may facilitate the practise of strategy changes.The right side of the above Figure 1 defines the final subsequent status of firms, once specific actions have been taken. Post-distress Status shows the effectiveness of the management effort in a crisis situation, not only because the firm solves the initial state, but also sin ce the new position is reached evidencing a well performance to set a suitable continuity in the new balanced situation. Accordingly, Post-distress status assesses the quality of firms welfare accounting for the risk to re-entry into distress discriminating well performers and best performers in a crisis management process. In a distress context, a well-performer just achieves the objective (i.e. exiting the crisis situation) while best-performers are located in a new healthy scenario minimizing the likelihood to reenter in distress.Hence, considering the above model, the following hypotheses will be testedH1 Severity degree of financially distressed firms is likely associated with the post distress status.H2 Reaction Capability of distressed firms is positively related to a fit final position after recovery process.H3 Performance in-distress is positively related with the welfare of the post distress status.H4 Retrenchment strategies have a positive influence on the outcome of a di stressed situation.H5 Size of financially distressed companies is associated with the final position after recovery process.Methodology, sample and variablesTo test the hypothesis we use the financial data of US firms derived from the Compustat Database in an eight year period 1993-2000 which is considered to be economically appropriate for the abstract. Smith and Graves (2005) affirm that in an economic expansion context distressed firms could easily perform a successful turnaround. Particularly, the US economy inhabitd an economic expansion during the analyzed period. According to the National Bureau of Economic Research (2001), a peak in business activity occurred in the U.S. economy in March 2001. A peak marks the end of an expansion and the beginning of a recession1. So, the year 2001 was pronounced by events like the Dot-Com Bubble, Stock Market Crash, the loss of investors confidence in the Stock Market or the emergence of corporate fraud and corporate governance. The kinf olk 11, 2001 attacks also, may have been an important factor in turning this decline in the economy into a recession. The financial data for the years after 2000 would be, to a greater or lesser extent, influenced by all these external factors.From a total of 1721 companies that offer complete data in their financial statements during all years, only the ones that presented a crisis situation in the first year of analysis, 1993, were selected.We consider a crisis status as a variety of enterprise adversity situations that threaten the future viability of the company (Turetsky and Mcwewn, 2001 Graveline and Kikalari, 2008), which show some incapacity to generate resources and/or to fulfill the payment of debts in time. This incapacity can be transitory and of a major or minor gravity and it can be observed through a series of symptoms alerting that the health and the future of the company are at risk. Considering this general approach and following Gonzlez-Bravo and Mecaj (2011), we classify a firm as financially distressed if, in the first year of our analysis, it presented one or more of the following criteria ban Net Income, Negative Operating Income, Negative Retained Earnings, Negative Working Capital, Negative Cash function, Negative Operating Cash Flow and Negative Shareholders Equity. In agreement with Gilbert, Menon and Schwartz (1990), to prevent the selection of firms that only had a poor performance in the starting year firms presenting merely a Negative Net Income for the year 1993 were not selected. This criterion made possible that poor performers were selected only when they also showed a continued instable situation such as losses in preceding years or solvency problems. As a result, our study is performed on a total of 526 companies that satisfied all the previous conditions. Table 1 shows the principal features of the analyzed sample.(Table 1 here)The number of observed symptoms permits an objective a priori classification based on the g ravity of the starting situation. A firm would experience a weak crisis if it presents three or less criteria and, on the contrary, a strong crisis if it shows 4 or more. Following this further, in the first year of the analysis 77.38% of the firms encounter a weak crisis while 22.62% are facing a situation of strong crisis.VariablesSeverity Status, Reaction Capability and fittingness Status, as typical indicators of post-distress position, in the above proposed model (Figure 1) are built by gathering information given by some individual variable-indicators according to the features evaluated. The complete celluloid integrating the model and variables is showed in Figure 2.(Figure 2 here)Severity status (SEV_STAT) should be understood as an index assessing the degree of severity distress by seven financial ratios. These ratios correspond to the 7 symptom-indicators used to classify a firm as being in financial distress previously described, all divided by substance Assets in ord er to eliminate the size effect. Ratios such as Net Income/Total Assets, EBIT/Total Assets and Retained Earnings/Total assets, representatives of the economic performance, are also commonly used to determine the existence of a decline phase in turnaround and recovery research (Pearce and Robins, 1993 Arogyaswamy et al., 1995 Smith and Graves, 2005). Negative Operating Cash Flow is also an indicator of liquidity deterioration and of financial distress probability (Anandarajan et al. 2001 Bell and Tabor, 1991 John, 1993). These seven indicators should be considered in a negative direction with respect to financial distress. That is, the lower value of the indicators, the worse the starting situation of the firm. In the same way, the more the number of negative indicators in a firm, the higher the crisis severity degree will be.Reaction capability is evaluated through three indicators Sales/Total Assets (TURNOV), Shareholders Equity/Total Liabilities (FIN_AUT) and on-going Assets/Curr ent Liabilities (SOLV). The first one reflects the capacity of the company to enhance profitability while the other two indicators are linked to the financial structure of a firm and enable us to value its self-sufficiency and solvency. Together, these three variables measure the capacity of a firm to obtain external and additional funds or to reorganize its debts, the short term response capacity and the ability to generate resources.Fitness status (FIT_STAT) is defined as an index measuring the final health position on an objective and on a quality base as well, by means of 4 variables. Final Position is a categoric variable which indicates the existence or not of a crisis situation, when the firm still presents any symptom of distress. This variable takes value 0 if the firm exits successfully and doesnt present distress signals or value 1 otherwise. Additionally, to measure the health quality of this position, we follow the approach of Jostarndt (2006) when he identifies three factors that could cause financial distress excessive leverage, a poor firm-specific operating performance and an industry downturn. These factors could be interpreted as indicators of the incapacity of a firm to generate cash flow which may influence a continuous economic and financial deterioration. The variables are defined as follows (For further details on all variables calculation refer to accompaniment B)Debt payment level it permits the evaluation of the effects that a higher debt level of a firm has on cash flow generation, with respect to the industry where it operates. It indicates the level of interest payment the firm is paying compared to the median of the sector. If the level is above the median, the firm is paying more than other firms, so it should reduce it.Firm Performance It measures the effects that a poor performance, lower than the median of the industry, has on cash flow generation. It measures the operating income of a firm compared to the median of the sec tor. It indicates if the firm is performing above or below the median of the sector.Sector performance it allows analyzing to what extent the trend of the performance of the sector where the firm operates influences its capacity to generate cash flow if it behaved as the industry average. This item measures the improvement or the deterioration of a sectors performance, compared to its performance the year before.These three variables measure the risk of distress which could be the consequence of leverage problems or economic issues, including the downturn of the industry. The former three defined ratio-indicators should be understood in a negative sense, thus, the higher the three ratios are, the worse the quality position of the firm and the greater the probability of financial distress. Therefore, Fitness Status variable measures the position of a firm t years after the financial distress has been detected, allowing to evaluate the performance in managing a difficult situation.Sev erity Status and Fitness Status indexes could be interpreted as two heterogeneous indicators gathering the information of 7 and 3 individual ratios, respectively. To overcome some of the drawbacks of aggregated indexes, such as the degree of subjectivity in attribution of weights to each individual component (Munda, 2005 Messer et al., 2006 Munda and Nardo, 2009 Ramzan et al., 2008), we decided to use Data Envelopment analysis to summarize the complex information in just one index (Nardo et al., 2005a Cherchye et al. 2008 Dyckhoff and Allen, 2001). DEA is a non-parametric performance measurement technique, based on a productivity approach, widely used to evaluate the relative efficiency of Decision Making Units (Cooper et al., 1999 Seiford, 1997 Gattoufi et al. 2004 Sherman and Zhu, 2006). However, this methodology has also been used to create indexes combining different components by means of an optimization process, when the structure of weights of these components is not known, and without making any assumption concerning the internal operations of a DMU (Cherchye et al., 2006 Zhu, 2000 and 2001 Puig-Junoy, 1998 Sexton and Lewis, 2003). Thus, both Severity Status and Fitness Status scores are obtained applying a DEA model without explicit inputs, called DEA-WEI models by Liu et al. (2011). This formulation, discussed by Lovell and Pastor (1999), considering a model with only outputs and a single constant input, has been used by Chen (2002) and Cooper et al. (2009), and it is similar to other approaches as DEA-R (Despic et al., 2007) or DEA-Index composite (Cherchye et al. 2008).Fitness Status use as DEA variables a series of indicators that measure negative features of a firm and they are also linked to the possibility of presenting a marked financial distress situation. This consideration is in agreement with the called pessimistic DEA approach, where the efficiency frontier contains, using Azizi and Ajirlu (2011) terminology, the worst-practisers as effi cient in being poor-performers. In this way, DMUs tally unity or close to unity levels will be the ones with higher degree of severity in their financial distressed situation. Furthermore, Fitness Score DEA manages a categorical variable Final Status indicating the existence or not of distress symptoms. In this sense we follow the approach of Banker and Morey (1986) concerning the treatment of exogenously fixed data.To measure the strategies and the behavior of firms during distress, profitability and downsizing actions have been included in the analysis. With regard to profitability, we use ROA in the last year of the analysis (ROA) and the average of its variations in the previous years (ROA_AVG) to measure the impact of efficiency oriented strategies to the final post-distress position. Concerning downsizing actions, variations in total assets during previous year are included to measure the impact of retrenchment strategies (RET_STG)Finally, to control the size effect (SIZE), natural logarithm of sales ln(sales) is included in the analysis in order to assess the influence of size on the possibility to return on a healthy scenario.MethodologyThe DEA score Fitness Status will be treated as a dependent variable in order to analyze to what extent post-failure position could be explained by issues such as severity, reaction capability or certain strategies implemented by the firms. Many different approaches can be found in the literature when a DEA score is used as a dependent variable of a regression to relate efficiency to the factors and study their influence on the former. The consideration of the DEA score as a censored variable (showing determine between zero and unity) has been the argument for using regression censored models such as Tobit. On the other hand, Mancebn and Molinero (2000) do not share this tone and affirm that efficiency takes natural limits of zero and one and they estimate a model of the log type to explain inefficiency. In the sam e line, Puig-Junoy (1998) considers that DEA scores do not fit the theory of sampling censoring for Tobit models explaining inefficiency by a multiplicativ