Corporate governance on financial distress: Evidence from Indonesia

Eka Handriani,Hersugodo Hersugodo,Imam Ghozali

doi:10.5267/j.msl.2021.1.020

Abstract

The main objective of this paper is to explore the most significant determinants of financial distress of manufacturing companies in Indonesia and to provide explanations on this issue by using multiple regression models. With Modigliani and Miller’s and Trade-off theories were reviewed to formulate a testable proposition on the determinants of financial distress of manufacturing companies in Indonesia. Multiple regression models were used as a statistical tool to investigate the most significant profitability determinants of manufacturing companies in Indonesia. The Lisrel software was used to analyze 300 manufacturing companies listed on the Indonesia Stock Exchange. It was found that institutional ownership, firm size, profitability, and board independence as variables had a positive relationship in an effort to avoid financial distress. Meanwhile, the board size variable had an insignificant positive relationship. The findings are consistent with the pecking order and financial agency theory which helps in understanding the application of financial distress studies for manufacturing companies in Indonesia.

Highlights

Companies in the United States of America (USA) had to restructure their corporate governance as a result of a market crash in 1929
This study aims to examine the effectiveness of internal corporate governance mechanisms consisting of institutional ownership, board size and board independence and profitability, financial expenses, retained earnings and firm size for the occurrence of financial distress
While Parsimony Goodness of Fit Index (PGFI) is a Goodness of Fit Indices (GFI) that has adjusted the impact of degree of freedom and model complexity

Summary

Introduction

Companies in the United States of America (USA) had to restructure their corporate governance as a result of a market crash in 1929. Unification of the interests of shareholders, debt holders, and management who are the parties aiming to maximize the shareholders’ prosperity as a company goal is not always easy and often creates agency problems. The modern capital structure theory that houses the first financial distress conditions is the theory of Modigliani and Miller (MM theory) They argue that capital structure is irrelevant or does not affect the value of the company. Myers and Marcus (1999) concluded that this MM without tax theory does not distinguish between indebted companies or the shareholders of the debt-bearing companies in a condition of without taxation and perfect markets. The financial managers cannot increase the value of a company by changing the proportion of debt and equity used to finance the company. This is what lies behind the MM theory as it ignores bankruptcy costs

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Conclusion