Empirical and theoretical literature of financial distress prediction: an application to the solvency test

Abstract

The objective of this study is to identify factors from the empirical and theoretical literature of financial distress which may aid us in evaluating and satisfying the solvency test. In achieving this objective, the empirical and theoretical literature on financial distress prediction is reviewed. This review covers the financial as well as the non-financial approach in predicting corporate failure. The intent of this review is to identify factors and financial measures which have been found to be significant predictors of financial distress and the theoretical implications of those measures. These measures are then applied to the solvency test. In addition, the thesis also briefly examined the change from the capital maintenance rule to the solvency test in New Zealand. The reasons for change were evaluated, and the problems surrounding the solvency test were also highlighted. This study found the variability of a firm's cash flow to be vital in assessing a firm's liquidity. Although there is little empirical support for this measure, many theoretical models suggest that the variability of a firm's cash flow is significant in the evaluation of a firm's liquidity. Some empirical studies attribute the insignificant results of their studies to the high variability of the financial measures employed. Further, cash flow analysis is important in the determination of a firm's liquidity. Some empirical studies cast some doubt over the usefulness of the current ratio which is a commonly used liquidity measure. Instead, the empirical literature suggest other liquidity measures such as the Quick ratio, Working Capital to Total Assets, Cash to Current Liabilities and Cash to Total Assets as better proxies for liquidity. The firm's profitability, interest coverage and the fluctuation in interest rates may also have some influence on the firm's liquidity. In relation to the balance sheet test, theoretical models suggest the use of market value which implies the use of realisable value in the valuation of assets. Empirical studies also found the support for the use of market value. A firm's solvency may be measured by the ratios, Net Worth to Total Debt, Retained Earnings to Total Assets and Total Liabilities to Total Assets as they have been found to be fair predictors of financial distress. In addition, a firm's leverage plays an important role in the assessment of a firm's solvency. Leverage reflects a firm's exposure to financial risk and thus, a highly levered firm will have a higher probability of being insolvent. This in turn affects the market value of the firm and the ability of the firm to obtain future financing. A firm's ability to achieve steady profitability and its ability to obtain continuous financial support is vital to the survival of the firm. In addition, the variability of the firm's profitability and variability of the firm's retained earnings are also important measures for consideration as suggested by the theoretical models of bankruptcy. The findings of this thesis has added to our understanding about the underlying process of insolvency and factors which may be possible causes of insolvency. Therefore, the factors and measures identified above may provide some guidance to directors in the satisfaction of the solvency test as required by the Companies Act 1993 (New Zealand).