CONTROL VARIABLES

Control variables are those variables that may influence the relationship between corporate governance and financial distress if they are not controlled. Empirical studies (Elloumi and Gueyié 2001; Laitinen 2005; Donker et al. 2009) examining corporate governance and financial distress have controlled certain firm characteristics that are supposed to impact on the corporate governance and financial distress relationship. Based on prior research, the control variables discussed below are identified.

5.3.4.1 FIRM SIZE

Firm size plays a significant role in determining the kind of relationship a firm enjoys within and outside its operating environment and that the larger a firm is, the greater the influence it has on its stakeholders (Ezeoha 2008). The size of a firm can influence its financial distress process. This is because, first, large firms may have better management and corporate governance to generate more reliable information, to be followed by a large number of analysts, and to have greater liquidity on the trading floor (Molina and Preve 2012). Second, the resource base view of the firm argues that large firms can draw more resources (both tangible and intangible) than the small firms can. Third, because large

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firms are well-established with a large asset base that can be used as collateral, they usually have better access to external sources of funds and are also able to avoid financial distress by using public equity markets (Polsiri and Sookhanaphibarn 2009). Banks are more willing to lend their funds to large firms partly because they are more diversified and partly because large firms usually request large amounts of debt capital than smaller firms (Eriotis et al. 2007). Thus, large companies have an advantage over small companies because they may have a longer history, more entrenched competitive positions, better access to credit, a more extensive bundle of assets that can be sold in the event of financial difficulty, and better diversification strategy (Kane et al. 2005). Hence, the effect of financial distress on trade payables should be less important for large firms that have better sources of financing. Due to these benefits enjoy by large firms, they are likely to fall into financial distress at a lower rate than small firms are. Thus, all things being equal, large firms, due to more resources and experience, tend to handle financial distress better than small companies (Pindado and Rodrigues 2005) and that the likelihood of financial distress is expected to reduce with increases in firm size. However, according to Parker et al. (2002), large firms seem to have greater difficulty in maintaining their ongoing operations during periods of financial distress. Laitinen and Suvas (2016) also argue that very small firms are flexible and can avoid high failure risk.

Empirically, Donker et al. (2009) find a statistically significant negative relationship between firm size and financial distress but Ciampi (2015) find no association between firm size and default. However, Parker et al. (2002) establish that firm size is significantly associated with the likelihood of bankruptcy but distressed firms exhibit an opposite association with the likelihood of bankruptcy than is expected. Hsu and Wu (2014) also find little evidence to show that there is a negative relationship between firm size and corporate failure. Given the resource accessibilities for large firms, they are less likely to be financially distressed when compared with small firms. The following hypothesis is therefore proposed for firm size.

H4a: Firm size is expected to have a negative relationship with firms’ likelihood of financial distress.

5.2.4.2 FIRM AGE

From Gaur et al. (2015), firm age is a measure of the longevity of a firm and affects the types of decisions that firms make due to path dependency in strategic planning. The age of the firm is usually seen as an essential factor affecting the financial distress process (Laitinen 2005). This is because firms that are old, due to their long existence, are deemed

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to have wider access to resources, finance, and link with well-established suppliers, as well as having a large customer base that may help them to perform better when compared with the young new firms. Also, Laitinen (1992) indicates that the financial distress process may be different for young businesses due to the lack of capital and cash flow generation. Firm age, together with experience and transparency, therefore, play a significant role for firms in gaining access to public equity or long-term debt financing (Uyar and Guzelyurt 2015). Hence, young new firms are likely to be distressed financially than old firms. According to Laitinen (1992),failure statistics show that over 50% of new ventures will fail during the first five years. Åstebro and Winter (2012) are also of the view that a standard result in the literature is that with increasing firm age the probability of failure decreases. However, Hsu and Wu (2014) find no significant association between firm age and the likelihood of corporate failure. Given that older businesses may have good links with suppliers, customers, and providers of finance and as such, are in a better position to handle financial difficulties than the new young ones, they are less likely to be financially distressed when compared with the new young businesses. The following hypothesis is therefore proposed.

H4b: Firm age is expected to have a negative relationship with firms’ likelihood of financial distress.

5.3.4.3 INDUSTRY EFFECTS

Industry plays a key role in the financial distress process. Every firm deal with a similar set of forces in any industry including the supply-chain forces and the competitive forces but each industry is assumed to have a unique set of forces (Arend 2009). The industry in which a firm operates determines its success or failure especially when there is a general economic and financial downturn. For instance, during the 2007 financial crisis, firms in the manufacturing, construction, retail, and financial service industries had the greatest impacts. Although the firms’ access to resources and their appropriate usage plays a key role in generating returns, firms placed in attractive industries can make even relatively more returns. Thus, the industry structure in which a firm operates is the main driver of performance variations (Hawawini et al. 2003) and the cause of some firms financial distress. The financial distress process may be different across industries and that El Hennawy and Morris (1983) and Platt and Platt (1990) have shown an industry effect when predicting firm failure. McGurr and Devaney (1998) apply failure prediction models developed on mixed industry samples to the retailing industry and observe low classification accuracy due to the industry effect. Laitinen (2005) find that the financial

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distress process is shown to be affected by firms’ industry. Given that some firms successes or otherwise come almost wholly from the industry in which they operate (Porter 1991), the following hypothesis is hereafter proposed.

H4c: There is a negative relationship between industry and firms’ likelihood of financial distress.