LINK BETWEEN CORPORATE STRATEGY AND BANKRUPTCY RISK: A STUDY OF SELECT LARGE INDIAN FIRMS

International Journal of Mechanical Engineering and Technology (IJMET) Volume 9, Issue 7, July 2018, pp. 119 126, Article ID: IJMET_09_07_014 Available online at http://www.iaeme.com/ijmet/issues.asp?jtype=ijmet&vtype=9&itype=7 ISSN Print: 0976-6340 and ISSN Online: 0976-6359 IAEME Publication Scopus Indexed LINK BETWEEN CORPORATE STRATEGY AND BANKRUPTCY RISK: A STUDY OF SELECT LARGE INDIAN FIRMS G. Sriram Department of Social Sciences, VIT, Vellore, Tamilnadu, India Vedantam Seetha Ram Department of Technology Management, VIT, Vellore, Tamilnadu, India ABSTRACT Firms face bankruptcy risk when they are unable to meet the principal and interest obligations towards the bondholders. The bankruptcy costs arising out of this risk put pressure on the firm value and also affect the stockholders. To predict the corporate bankruptcy, Altman Z Score, which is based on firms liquidity, profitability, earnings ability, market value and asset turnover is considered appropriate. The current study is an evaluation of relationship between corporate strategy adopted and bankruptcy risk experienced by the firms, categorized as concentrated and diversified firms. Since corporate strategy applied alters asset composition, which in turn influence their financial leverage thus allowing management understand the choice of strategy and its influence on bankruptcy risk. Hence, Altman Z score methodology is applied on select large manufacturing firms that earned more than 100 million in revenue during the financial years 2009-10 through 2015-16 categorized as concentrated and diversified firms based on Herfindahl index. Results show that concentrated firms face slightly lower bankruptcy risk than diversified firms. This may be because concentrated firms fare better than diversified firms on performance, sales and profitability. Key words: Altman Z score, Bankruptcy Risk, Bond Holders Corporate Strategy, Herfindahl Index. Cite this Article: G. Sriram and Vedantam Seetha Ram, Link Between Corporate Strategy and Bankruptcy Risk: A Study of Select Large Indian Firms, International Journal of Mechanical Engineering and Technology 9(7), 2018, pp. 119 126. http://www.iaeme.com/ijmet/issues.asp?jtype=ijmet&vtype=9&itype=7 1. INTRODUCTION Firms face bankruptcy risks when they are unable to meet their fixed obligations like payment of interest to long term creditors etc. The bankruptcy risks seriously jeopardize the fund raising activities of the firm. There are many direct and indirect costs involved in corporate bankruptcy. http://www.iaeme.com/ijmet/index.asp 119 editor@iaeme.com

G. Sriram and Vedantam Seetha Ram Researchers have attempted many methods to predict the corporate bankruptcy. These include statistical models such as multiple discriminant analysis, linear probability models, and logit models. Altman [1] has applied multiple discriminant analysis to identify five important ratios that help us to identify the probable bankruptcy firms. Altman s Z score is considered very useful by many researchers in predicting bankruptcy. 2. REVIEW OF LITERATURE Predicting bankruptcy has been an important endeavor by finance researchers. Altman Z score is one such tool to predict the bankruptcy risks faced by firms. He used ratio analysis for this purpose. Initially by applying multiple Discriminant Analysis, he has identified five variables including liquidity, profitability, leverage, and solvency and activity ratios to predict bankruptcy risk and suggested that firms having Z score greater than 3.00 are free of bankruptcy risk and firms with scores less than 1.80 are likely to become bankrupt. Jerold B. Warner [2] considered the role of bankruptcy costs in determining the capital structure of firms. He has claimed that not all bankruptcy costs are measureable, direct costs. There are indirect costs that are substantial. The direct costs of bankruptcy are accountant and lawyers fees, and the time spent by management on administering bankruptcy. The indirect costs are lost sales, lost profits, credit constraints faced by firms and inability to issue securities. Arindam Bandyopadhyay[3] using a sample of 104 listed corporations from CRISIL, developed a Z score model for Indian firms that can accurately predict bond default one year in advance. The model had a high classification power within sample (91percent), but also exhibited a high predictive power in its ability to detect bad firms in the two hold out samples (with 92 percent and 88percent accuracy rates). The model predicted corporate bankruptcy in two year prior to financial distress with an accuracy rate of 97 percent and 96.3 percent respectively. James A. Ohlson [4] used data collected during 1970-76. He identified four factors that were statistically significant. They are size, a measure of financial structure, a measure of performance, and a measure of liquidity to predict corporate bankruptcy. The prediction error rate was larger in comparison to the rate reported in the original Altman paper. Daily and Dalton [5] suggested a relationship between governance structure and bankruptcy. They found that dual structures (one person with two official positions) was 37.5 percent in survivor firms and 53.8 percent in bankruptcy firms. Siew Bee Thai et al [6] used discriminant analysis to predict financial distress of the companies in Malaysia. They found that working capital to total assets was the most significant variable that discriminated between financially distressed and financially non-distressed firms. The MDA model they developed achieved an accuracy rate of 76.7 percent to predict financially distressed companies in Malaysia. Hence, it is suggested that corporate strategy decisions also will have a bearing on the bankruptcy risks faced by firms. 3. METHODOLOGY The samples for this study were collected from a universe of private listed companies by NSE and BSE for the financial years from 2009-10 to 2015-16. Companies with profit after Tax more than 100 million were only selected for the study as only these companies are believed to have the necessary information. Further only manufacturing firms were selected for the http://www.iaeme.com/ijmet/index.asp 120 editor@iaeme.com

Link Between Corporate Strategy and Bankruptcy Risk: A Study of Select Large Indian Firms study using the NIC classification. All the product segment related information of these samples were collected from the database CMIE PROWESS. 3.1. Measuring Corporate Strategy As the objective of this study is to analyze the bankruptcy risks faced by concentrated and diversified firms, the sample firms needed to be separated accordingly. Herfindahl index was used for this purpose. The index is calculated across n business segments as the sum of the squares of each segment i s sales, S i as the proportion of total sales. n n 2 2 H = S i S i i =1 i =1 (1) The Herfindahl index value lie between 0 and 1. A firm is classified as concentrated if it has HI value closer to 1, diversified if it has HI value closer to 0. In this study, the bench mark HI score of 0.50 is used to divide the companies as concentrated and diversified firms. Table 1, shows the classification of samples in this way, for financial years from 2009-10 to 2015-16. Table 1 Classification of Sample Firms Year Total Firms Diversified Firms Concentrated Firms FY 147 37 110 FY 192 51 141 FY 212 59 153 FY 205 55 150 FY 200 53 147 FY 177 43 134 FY 167 37 130 3.2. Measuring Bankruptcy To measure the bankruptcy risk faced by concentrated and diversified firms, the following method advocated by Altman is used. Altman Z score = 1.2 A + 1.4 B + 3.3 C + 0.6 D + 1.0 E (2) Where, A = Working Capital / Total Assets B = Retained Earnings / Total Assets C = EBIT / Total Assets D = Market Value of Equity / Total Liabilities E = Sales / Total Assets The financial information relating to the above model is obtained for the sample firms, classified as concentrated and diversified firms from the CMIE PROWESS database for the selected period. To test the mean differences between concentrated and diversified firms, independent sample t test is applied. Further, to identify the factors that contribute to the differences in bankruptcy risks faced by the two groups of firms, individual component of the bankruptcy model is analyzed. http://www.iaeme.com/ijmet/index.asp 121 editor@iaeme.com

3.3. Research Objectives G. Sriram and Vedantam Seetha Ram To find whether bankruptcy risks faced by concentrated and diversified firms are different. To identify the factors that contribute to those differences in bankruptcy risks between concentrated and diversified firms. 3.4. Hypotheses The mean bankruptcy scores of concentrated and diversified firms are not different. The mean working capital to Total Assets ratio of concentrated and diversified firms are not different. The mean Retained Earnings to Total Assets ratio of concentrated and diversified firms are not different. The mean EBIT to Total Assets ratio of concentrated and diversified firms are not different. The mean market value of Equity to Total liabilities ratio of concentrated and diversified firms are not different. The mean sales to Total Assets ratio of concentrated and diversified firms are not different. 4. RESULTS AND DISCUSSION The sample firms collected for financial years from to were classified as concentrated and diversified firms. The sample size of these firms are given in table 1. Using the Altman Z score methodology (Refer Equation.2), the bankruptcy risks faced by concentrated and diversified firms are calculated and compared using the simple two sample t test. The results are given in TABLE 2. Table 2 The Bankruptcy Scores of Concentrated and Diversified Firms (Independent Sample T Test) Diversified Firms Concentrated Firms T - Statistic 2.13 2.35-1.017 2.31 2.48-1.180 2.39 2.46 -.498 2.28 2.50-1.488 2.10 2.40-2.091* 2.19 2.59-2.083* 2.78 2.96 -.792 * Significant at 0.05 level According to Altman, firms with scores above 3.0 are unlikely to enter bankruptcy and firms with scores below 1.8 are headed for bankruptcy. From TABLE 2, it is observed that the mean Z scores of concentrated firms are slightly higher than the diversified firms, indicating that concentrated firms face a lower bankruptcy risk compared with diversified firms. The mean difference in bankruptcy scores are statistically significant for the financial years and. Hence the null hypothesis that the mean bankruptcy scores are not different between concentrated and diversified firms can be rejected for these years. There are factors that make the concentrated firms face lower bankruptcy risks than diversified firms. Further analysis is needed to understand those factors that contribute to the differences. For this purpose, the components of Altman Z score formula are analyzed separately. http://www.iaeme.com/ijmet/index.asp 122 editor@iaeme.com

Link Between Corporate Strategy and Bankruptcy Risk: A Study of Select Large Indian Firms Table 3 The Ratio of Working Capital to Total Assets (Weighted) Comparison of Diversified and Concentrated Firms (Independent Sample T Test) P Value P Value Div. Con. (One Tail) (Two Tail) 43.22 0.39 1.71 0.04 0.08 (67.00) (0.15) 3.72 0.36 1.68 0.04 0.09 (560.0) (0.04) 0.40 0.36 1.10 0.13 0.27 (0.04) (0.04) 0.41 0.40 0.44 0.33 0.66 (0.04) (0.04) 0.40 0.40 0.03 0.48 0.97 (0.03) (0.05) 0.38 0.42-0.77 0.21 0.43 (0.03) (0.06) 0.39 0.43-0.76 0.22 0.44 (0.05) (0.06) TABLE 3 shows the mean differences in the ratio of working capital to Total Assets between the two groups of companies. The mean differences are statistically significant for two years, and. Hence, the null hypothesis, mean Working Capital to Total assets are not different can be rejected for these two years. Further, it is noted that diversified firms possess slightly better short term liquidity compared to concentrated firms for some sample years. Table 4 The Ratio of Retained Earnings to Total Assets (Weighted) Comparison of Diversified and Concentrated Firms (Independent Sample T Test) Div. 0.023 0.03 0.04 0.02 0.02 0.02 0.03 Con. 0.05 (0.01) 0.05 0.05 0.04 0.04 0.03 0.04 P Value P Value (One Tail) (Two Tail) - 1.82 0.03 0.07-2.07 0.01 0.03-1.14 0.12 0.25-2.21 0.01 0.02-1.35 0.08 0.17-0.62 0.26 0.52-2.16 0.01 0.03 TABLE 4 shows mean differences in the ratio of retained earnings to Total Assets between concentrated and diversified firms. It is observed that concentrated firms fare slightly better than the diversified firms and the differences show statistical significance for financial years,,, and. Investment opportunities faced by firms can be an important factor in determining the level of retained http://www.iaeme.com/ijmet/index.asp 123 editor@iaeme.com

G. Sriram and Vedantam Seetha Ram earnings. Generally concentrated firms face better investment opportunities than the diversified firms and the results show a contradictory scenario during the study period. Table 5 The Ratio of EBIT to Total Assets (Weighted) Comparison of Diversified and Concentrated Firms Div. 0.108 0.11 0.12 (Independent Sample T Test) Con. 0.127 0.13 0.12 P Value P Value (One Tail) (Two Tail) - 1.28 0.09 0.19-1.28 0.10 0.20-0.19 0.42 0.84 Concentrated firms perform better compared with diversified firms on profitability, 0.10 0.12-1.35 0.08 0.17 0.10 0.11-0.79 0.21 0.42 0.10 0.12-1.50 0.06 0.13 0.11 0.12-0.65 0.25 0.51 measured as the ratio of EBIT to Total Assets. The null hypothesis of no difference can be rejected for financial years 2009-10, and. There are empirical studies which have shown than concentrated firms perform better in terms of profitability. For example, Wernerfelt and Montgomery [7] estimated the importance of focus in determining firm performance. They found that firm effects existed in the form of positive focus effects. But industry effects existed as a reason for the majority of variance. Table 6 The Ratio of Market Value of Equity to Total Liabilities (Weighted) Comparison of Diversified and Concentrated Firms Div. 0.54 (0.99) 0.86 (0.95) 0.78 (1.10) 0.76 (1.68) 0.71 2.09 0.86 3.06 1.63 5.66 (Independent Sample T Test) Con. 0.12 0.93 (1.02) 0.81 (0.85) 0.79 (1.06) 0.71 (1.12) 0.82 (1.45) 1.58 6.09 P Value (One P Value (Two Tail) Tail) 4.37 9.48 1.89-0.47 0.34 0.68-0.18 0.42 0.85-0.16 0.43 0.87 0.01 0.49 0.99 0.16 0.43 0.87 0.11 0.45 0.91 http://www.iaeme.com/ijmet/index.asp 124 editor@iaeme.com

Link Between Corporate Strategy and Bankruptcy Risk: A Study of Select Large Indian Firms The TABLE 6 shows the market capitalization of concentrated and diversified firms. It shows the market s reaction to firms liabilities. It is evident that the differences are not significant between the two groups of firms. Hence, the null hypothesis that there is no difference in the ratio between concentrated and diversified firms cannot be rejected. Table 7 The Ratio of Sales to Total Assets (Weighted) Comparison of Diversified and Concentrated Firms Div. 0.98 (0.22) 0.92 (0.17) 1.20 (3.00) 1.33 (7.36) 0.91 (0.18) 0.93 (0.20) 1.03 (0.21) (Independent Sample T Test) Con. 1.06 (0.35) 1.05 (0.40) 1.09 (0.50) 1.12 (0.42) 1.09 (0.31) 1.16 (0.37) 1.16 (0.35) P Value (One P Value (Two Tail) Tail) - 0.76 0.22 0.44-1.30 0.09 0.19 0.69 0.24 0.49 0.88 0.18 0.37-2.00 0.02 0.04-2.23 0.01 0.02-1.20 0.11 0.23 TABLE 7 shows the mean differences in the ratio of sales to Total Assets between the two groups of firms. Concentrated firms have higher sales to assets ratio than diversified firms for 5 out of 7 years. The mean differences are statistically significant for years, 2013 14 and. The reason why concentrated firms fare better in this ratio can be attributed to issues such as governance, managerial efficiency, and agency cost. Ang et al [8] used this ratio to test the agency cost faced by firms and its link with the ownership structure. He found that insider owned firms had a higher sales to total assets ratio implying lower agency costs faced by those firms. In summary, the hypotheses 1 to 4 and 6 are rejected while hypothesis 5 cannot be rejected based on the data. 5. CONCLUSIONS Bankruptcy risks refer to the inability of business firms to meet their fixed obligations towards the debt holders. The analysis of bankruptcy risks faced by concentrated and diversified firms show that concentrated firms face lower bankruptcy risks compared to diversified firms. Further investigation show that concentrated firms have higher retained earnings, sales and profitability ratios than diversified firms which are the reasons for concentrated firms experiencing lower risks. However, diversified firms have better short term liquidity than concentrated firms. REFERENCES [1] Altman, Edward. I (1968), Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy, The Journal of Finance, Vol.23, No.4, pp 584 609. [2] Warner, Jerold B (1977), Bankruptcy Costs some Evidence, The Journal of Finance, Vol.32, No.2, pp 332 347. http://www.iaeme.com/ijmet/index.asp 125 editor@iaeme.com

G. Sriram and Vedantam Seetha Ram [3] Bandyopadhya, Arindam(2006), Predicting probability of default of Indian corporate bonds: logistic and Z-score model approaches, The Journal of Risk Finance, Vol 7, No 3, PP 255-272. [4] Ohlson, James. A (1980), Financial Ratios and the Probabilistic Prediction of Bankruptcy, Journal of Accounting Research, Vol 18, No 1, PP 109-131. [5] Daily, Catherine M and Dan R. Dalton (1994), Bankruptcy and Corporate Governance; The impact of Board Composition and structure, Academy of Management Journal, Vol.37, No.6, pp 1603-1617. [6] Bee, Thai Siew and Mehdi Abdollahi (2011), Corporate Failure Prediction: Malaysia's Emerging Market, The International Journal of Finance, Vol 23, No 2. [7] Wernerfelt, Berger and Cynthia A.Montgomery (1988), Tobin's q and the Importance of Focus in Firm Performance, The American Economic Review, Vol 78, No 1, PP 246-250. [8] Ang, James.S, Rebel A Cole, and James Wu Lin( 2000), Agency Costs and Ownership Structure, The Journal of Finance, Vol 35, No 1, PP 81-106. http://www.iaeme.com/ijmet/index.asp 126 editor@iaeme.com