Abstract
Unstable economic conditions have an adverse impact on the financial performance of firms, leading to financial distress, which is an unfavourable situation for investors as it may affect their investment returns. Thus, this study attempted to predict financial distress and to examine the effect of financial distress on stock returns by using firms listed on Bursa Malaysia from 1990 to 2020. This study used the logit model to find the probability of bankruptcy and also as a proxy for financial distress risk in the asset pricing model. From this study, financial distress risk was found to be insignificant in pricing stock returns in all tested models. This finding demonstrates that financial distress risk does not affect stock returns since this risk may be eliminated through diversification.
Highlights
Uncertainties in economic conditions can affect the financial performance of firms and in some cases, lead to financial distress
The results showed that financial distress firms tended to have negative sales to working capital (SWC), earnings before interest and tax to sales (EBITS), net profit margin (NPM), and interest coverage ratio (ICR)
This study focused on predicting financial distress based on the Malaysian stock market and investigated the effects of financial distress risk on stock returns
Summary
Uncertainties in economic conditions can affect the financial performance of firms and in some cases, lead to financial distress. This situation affects small firms and listed firms. Based on the records of Bursa Malaysia, or the stock exchange of Malaysia, the number of firms classified as Practice Note 17 (PN17) firms increased from 21 firms in 2017 to 24 firms in 2018 These numbers may seem small compared to the total number of firms in the market, but firms’ bankruptcy risk level and shareholder return may be affected if this increasing trend continues. A firm is considered financially distressed if it cannot meet its current obligations and the value of its assets is less than the value of its liabilities. This definition is in accordance with studies conducted by Altman (1968) and Ohlson (1980), which are considered to be among the earliest studies on predicting financial distress
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