Financial ratios as the predictor of corporate distress in Malaysia

Abstract

The 1997 Asian Financial Crisis severely impacted Malaysia’s domestic economy. In the space of just 3 short weeks, almost RM300 billion in market capitalization was wiped off the local bourse. While some argue the situation had been predicted, clearly the depth and suddenness of the event had caught many by surprise. To many Malaysians, the occurrence of the financial crisis highlighted the need for firm action and activities to be constantly monitored and regulated. As the value of listed firms are often supported by the use of funds supplied by the general public, the potential loss in equity value as a direct or indirect result of firm distress, bankruptcy, and reorganization could have wide ranging effects. Clearly, a pre-emptive tool to identify potential problems had to be developed. One tool often cited was through the use of financial ratios. First developed around the turn of the 20th century, research argued that it could predict firm health with a 78% accuracy rate up to five years before distress or failure.

In order to evaluate the usefulness of financial ratios to predict firm status in Malaysia, data for firms listed on the Industrial sector of Bursa Malaysia’s Main Board were collected. By compiling the data in the form of financial ratios, we hoped that differences between those from healthy firms and those from distressed firms could be evaluated. Through the use of a ratio analysis, tests of significance, and logit analysis, we found that financial ratios did indeed discriminate the two groups. For almost all ratios tested, the difference between the two groups was found to be statistically significant. Furthermore, by comparing the two groups based on their liquidity and profitability, results indicate that firm distress or failure could be predicted based on these characteristics.