Review Of Financial Distress In Companies Finance Essay

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For this study, the literature review that will support the researchers findings is based on the independent variable of the study which is liquidity, leverage, activity and profitability. The researcher will find all the significant information that has been done by the previous researcher on the distress companies and the information gather will be use in this research to support the findings later on. Based on the previous study they also measure the relationship between the financial distress by using all the ratio. Therefore the ratio that common used to interpret the financial distress by using this financial ratio.

2.1 Financial distress in companies

Based on previous research by Altman, Ling Zhang and Jerome Yen (2007), there are a lot of research has been done by the previous researcher and there are some definition of the financial distress such as :

There are three stages of the financial problem which is temporary bankruptcy, uncovered debt burden and reorganization (as cited as Guthmann and Dougall,1952).

There are four causes of financial distress such as too much competition, occur an unprofitable expansion, no demand on their company product or services, and too much burden on payment of capital charges. (as cited as Dewing,1952).

Failure companies is also defined as bankruptcy, bond default, excessive or overdrawn on the bank account and inability to pay dividend on their preferred stock. (as cited as Beaver,1966).

Other than that, failure of the company is the bankruptcy that has been filed under the bankruptcy petition under Chapter X of the Bankruptcy Act of 1938. (as cited as Altman,1968)

Lastly, there are four stages of the financial problem which is declining too much before declaring the bankruptcy, incubation, shortage in cash, and financially insolvency. (as cited as Newton,1975).

2.2 PN4 vs PN17

According to Ruhani and Woon Jeng Hoong (2003) Practice Note No. 4/2001 or known as PN4 companies was introduced by the Kuala Lumpur Stock Exchange (KLSE) in March 2001 and it shows that the companies has financially difficulties. When they were listed under the PN4, the company must submit their plan on restructuring their financial position between six to twelve months to avoid their company listed as the financial distress, thus they must submit their plan to the KLSE. However, PN4 is only applicable from 15 February 2001 until 2nd January 2005.

While according to Syahida and Rashid (2010) after Pn4, the Practice note 17 was introduced by the KLSE and applicable starting from the 3rd January 2005 and apply the same criteria as the PN4 that basically about the financial problem of the company. This PN17 is with the unsatisfactory financial condition also have only 8 months to submit their plan of reorganize their financial problem to Bursa Malaysia.

2.3 The relationship between liquidity and financial distress

Liquidity is the ability of the companies to pay their debt to their creditors. Besides that, liquidity also used to measure the companies ability to meet their short term obligation (S.Ganesalingam,2001).

The researchers want to know the companies current ratio to see wether the companies assets can cover their liabilities. According to Mohd Azhar (2008), he found that the most important reason of health and unhealthy companies in Malaysia is mostly determine by the liduidity ratio.

According to Edith S. Hotchkiss, Kose John, Robert M. Mooradian And Karin S. Thorburn (2008) company that face financial distress will also facing the liquidity problem that also might effect their ability to meet their short term obligations. When they having problem in their liquidity which means they assets is lower and cannot covered the liabilities of the companies.

According to Syahida and Rashid (2010) the main cause of the companies suffering the difficulty in their financial is because of the low profitability and low liquidity positions and the distressed companies is more serious to recovered back or restructuring again their financial to avoid the bankruptcy.

Based on study by Edward,Ling Zhang and Jerome Yen (2007) liquidity is the indicator of measuring the short term financial status. Besides that, liquidity is directly shows the company ability in providing cash, cover their short term liabilities and the other normal operation. A high liquidity ratio determines that the company can quickly cover their short term liabilities, however too high of liquidity ratio is not indicates good because it will no generate high profit due to too much assets.

2.4 The relationship of the leverage and the financial distress

Leverage is a debt management that measure the ability of the companies to meet their long term obligation and the debt of the companies at that time (S.Ganesalingam,2001).

Leverage is also the basically the debt of the companies own. According to Mohd Azhar (2008) studies that companies with a high leverage tend to lose their substantial market share. By the time they lose their market share, they will have the possibility be listed in PN17 of the Bursa Malaysia. So, when they are listed as a PN17 companies, they should submit their solution to restructuring their companies and to be de-listed in the Bursa Malaysia.

In study of Edith S. Hotchkiss, Kose John, Robert M. Mooradian And Karin S. Thorburn (2008) when the companies leverage increase, they will also increase the potential of the companies to facing default and bankruptcy. Besides that, companies with high leverage in financial distress, their claimholder may have conflict to their investment decision because of the riskness to the potential of bankruptcy.

According to Tsun-Siou Lee Yin-Hua Ye (2001) On average, the unhealthy company that listed as financial distressed usually reach 59% of debt ratio in year and the healthy companies was only 42.39%.

In study of Yu-Chiang Hu and Jake Ansell (2006), the higher leverage of the companies does not means that it ahve a higher debt risk, since the leverage is depending on the composition of the leverage. The leverage analysis should be more focus on the financial leverage rather than the operating leverage. Operating leverage is such as a loan for store equipments purchasing in the retail industry, it may caused by the demand of the cutomer’s hence it is not so risky to the companies (as cited as Fitch,2000). So, the leverage should be measure using thier financial leverage and not the operating leverage.

According to Edward,Ling Zhang and Jerome Yen (2007), leverage is about the amount of liabilities which needed to be paid. There is an advantage from the financial leverage that basically in the trading of the equity. The company raise their loan to obtain an extra on their equity.

2.5 The relationship between profitability and financial distress

According to Syahida and Rashid (2010) profitability has a significant in determining the failure companies that had survival potential from those which would liquidate (as cited in Taffler,1983 and Rouledge and Gadenne,2000)

In study of Mohd Azhar (2008) the profitability of the company can be measure by the retained their profitability or losses by measuring all the profitability ratio. Besides that, he found that profitability and liquidity have a highly significant in the bankruptcy prediction model in accurating to the companies failures.

According to Zulkarnain (n.d) all the data involves such as the liabilities , assets , inventory, sales and others in balance sheet and income statement is basically relates to the profitability of the companies. All the variable will support either the companies will occur profit or loss and usually in Malaysian companies is experienced losses that can change to failure due to exceed in borrowings.

2.7 The relationship between activity ratio and financial distress

Activity ratio can measure a firm's ability to convert different accounts within their balance sheets into cash or sales. According to Edith S. Hotchkiss, Kose John, Robert M. Mooradian And Karin S. Thorburn (2008) all the activity ratio such as the inventory turnover and other activity by investors can contibute to the importance of changes in the financial distress companies. Besides that, the activities of theinvestors in their equity investment together with the management and board turnover can significantly contribute to the changes in any governance of the distressed companies.

According to Edward,Ling Zhang and Jerome Yen (2007), total asset turnover ascertain the efficiency of the company in utilising their asser. A high ratio is indicating the the company ability in selling their assets.

Therefore, based on all the previous study all of the ratio is significant to the financial distress of the company.