Board Characteristics and Financial Distress
Evidence from S&P 1500 CompaniesJune, 2018
Name: Hana Fejzović Student number: 10799125 Thesis supervisor: Dr. A. Sikalidis Date: June 25, 2018
Word count: 14,873
MSc Accountancy & Control, specialization Accountancy Faculty of Economics and Business, University of Amsterdam
Statement of Originality
This document is written by student Hana Fejzović who declares to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.
The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
Abstract
Once companies enter into financial distress, bankruptcy could follow, which could affect a lot of stakeholders, as was the case in the different financial scandals. Anticipating in risk factors regarding default is of high importance and it is stated that corporate governance could be a possible solution to financial stability. However, which corporate governance structure is optimal is not determined due to inconclusive findings in the literature. Therefore, this thesis examines the relation between the board characteristics of S&P 1500 firms and the likelihood of financial distress. A sample of 8,774 S&P 1500 firm-year observations over an eight-year period starting from 2007 to 2016 is used. Default risk is measured with the interest coverage ratio. The following board characteristics were investigated: board independence, board size and board diversity. Using a logistic regression analysis, the study confirms that firms with a higher percentage of independent board members are less likely to get into financial distress. Further results indicate that firms with a higher percentage of female board members are less likely to get into financial distress. Also, firms with more board members are less likely to get into financial distress. Those findings are supported by the additional analysis that has been executed. This additional analysis measured financial distress with the Altman Z-Score formula. This study contributes to the literature by further indicating that corporate governance is of high importance. In addition, it contributes to the inconclusive findings regarding the effect of board characteristics on the financial position of firms, by showing the effect of certain board characteristics on the likelihood of financial distress.
Contents
1 Introduction ... 7
2 Literature review and hypothesis development ... 11
2.1 Financial distress ... 11
2.2 Different theories regarding corporate governance ... 12
2.2.1 Agency theory ... 12
2.2.2 Stewardship theory ... 13
2.2.3 Resource dependence theory ... 13
2.3 Board characteristics ... 14
2.3.1 Board independence ... 15
2.3.2 Board size ... 17
2.3.3 Board diversity ... 19
2.4 Hypothesis development ... 20
2.4.1 Board independence and the likelihood of financial distress ... 20
2.4.2 Board size and the likelihood of financial distress ... 21
2.4.3 Females in the board and the likelihood of financial distress ... 22
3 Data and method ... 23
3.1 Sample selection ... 23 3.2 Research design ... 24 3.2.1 Regression model ... 24 3.2.2 Variable description ... 24 4 Results ... 29 4.1 Descriptive statistics ... 29 4.2 Multicollinearity tests ... 30 4.3 Regression Analysis ... 31 4.4 Additional Analysis ... 34
References ... 39 Appendices ... 46
LIST OF TABLES
Table Page
1 Sample selection procedure 23
2 Variable description 25
3 Descriptive characteristics 29
4 Correlations 30
5 Logistic Regression Results 32
6 Additional analysis – Variable description 35
7 Additional analysis – Logistic regression 36
1 Introduction
In the globalized and competitive business environment where firms nowadays operate in, financial distress has become an important concept were firms need to anticipate in (Thim, Choong, & Nee, 2011). Once firms enter into financial distress, it can be hard to recover out of this, so prevention is the cure. Financial distress occurs when companies fail to meet their obligations to creditors (Berk & DeMarzo, 2011). Once companies enter in financial distress, bankruptcy could follow, which could affect a lot of stakeholders, as was the case in the different financial scandals like Enron and WorldCom (Darrat, Gray, Park, & Wu, 2016). Therefore it is important to anticipate risk factors regarding default. It is argued that corporate governance could be a possible solution to financial stability (Manzaneque, Priego, & Merino, 2016). However, corporate governance is a set of mechanisms that is constantly affected by change, therefore it is not sure which corporate governance factors are optimal in the dynamic environment firms operate in. “Boards of tomorrow need to reflect upon, and understand, the dynamics of
society today and be prepared for constant change at an ever increasing pace” (Nash & Freeman, 2017).
According to the above, this study investigates the relation between the board characteristics of S&P 1500 firms and the likelihood of financial distress. The choice to focus on S&P 1500 firms is because of the following reasons. First of all, the sample is representative for the U.S. economy, since the S&P 1500 includes all stocks in the S&P 500, S&P 400, and S&P 600 (S&P Dow Jones Indices, 2018). This index covers 90 percent of the market capitalization of U.S. stocks. S&P standards are widely used by different investors; therefore it highlights the importance to investigate the board characteristics of those firms, to see which characteristics contribute in a positive way to the firms, and therefore to the investors.
Nowadays, “refreshment” of boards is among the most hotly debated topics across U.S. boardrooms (ISS, 2018). Therefore, this study aims to examine the effect of certain board characteristics on the likelihood of financial distress. There are many board characteristics, however, this research focuses only on the following characteristics, considering the board of directors: (1) board size, (2) board independence & (3) board diversity.
Within this refreshment of board’s concept, there has been a lot of discussion about how corporate boards could be improved and what factors should be reconsidered (Manzaneque, Priego, & Merino, 2016). The crisis has highlighted two important issues: (a) the inability of the agencies credit ratings, governments and financial creditors to anticipate and prevent firms’ financial distress situations; and (b) the importance of effectiveness of corporate governance mechanisms in crisis contexts (Husson-Traore, 2009, p. 50). According to Husson-Traore, good
corporate governance may ensure that firms meet their obligations, especially regarding debt repayment. Proper corporate governance may therefore mitigate the effect of default risk across firms.
In order to assess how corporate governance could create value for firms, first it should be considered how certain board characteristics of the firms affect the firm. The board of directors can be seen as the primarily corporate governance mechanism (Walsh & Seward, 1990). The board of directors monitors the management of the firms and could reduce the possible agency problems and therefore enhance firm performance (Fama & Jensen, 1983). A broad discussion nowadays is as to whether the board of directors should consist of more or less independent directors. There are controversial findings regarding this aspect, however there is a lot of support regarding the fact that board independence could reduce possible financial distress. Another highly debated topic is the board size of firms. Some argue that a larger board size would lessen coordination and communication (Guest, 2009; Coles, Daniel, & Naveen, 2008; Jensen, 1993), whereas others argue that a larger board size would provide the firm with more resources (Cowen & Marcel, 2011; Daily & Dalton, 1994).
There is increasing interest in the diversity of the boards, for example the call for more women in the boardrooms (Adams & Ferreira, 2009; Upadhyay & Hongchao, 2014). The recently mandatory quotas – in Europe, not in the U.S. – state that there should be a minimum percentage of women in the boardroom (Kirsch, 2018). Gender diversity could assist firms by bringing different perspectives, experiences and networks to the board, also women are more ready to discuss difficult issues, engage in independent thinking, and improve board communication (Adams & Ferreira, 2009; Huang, Yan, Fornaro, & Elshhat, 2011). So, the goals of the board of directors are divergent, but one of the main goals is to overcome financial distress and to increase performance (Brédart, 2014). However, whether more women in the board enhance firm performance is still equivocal (Perryman, Fernando, & Tripathy, 2016).
According to the above inconclusive findings, more research is needed in order to find out what factors of corporate governance contribute to optimal financial performance. Therefore, the following research question is stated:
RQ: What is the relation between the board characteristics (board independence, board size & board diversity) of S&P 1500 firms and the likelihood of financial distress?
Prior literature investigated from the 1980s on the importance of corporate governance and its influence on financial distress or bankruptcy (Daily & Dalton, 1994; Fich & Slezak, 2008; Chiang, Chung, & Huang, 2015; Manzaneque, Priego, & Merino, 2016; Brédart, 2014). Despite the extension of previous literature, it has been limited to certain context (U.S. Firms).
To answer the research question, a sample of 8,774 firm-year observations of S&P 1500 firms is used, focusing on a time frame from 2007-2016. The starting point 2007 is chosen because there is no earlier data on board characteristics available in the databases. The end point 2016 is chosen because it is the latest data that is available, and therefore it is the most recent data. Also, this period includes the financial crisis, which highlights an important moment in the global economy that is still affecting the economy.
Providing an answer to this research question is important for many reasons. First of all, it contributes to academic research since it adds to the inconclusive findings on corporate governance and the effect on the financial position of firms. Specifically, results form this thesis indicate that firms with a higher amount of independent directors will be less likely to experience financial distress. This finding is in line with other conducted researches (Manzaneque, Priego, & Merino, 2016; Chiang, Chung, & Huang, 2015) and therefore adds to the mixed results regarding the effect of board independence on the financial position. Results also indicate that boards consisting of a higher amount of women are less likely to experience financial distress. This result adds to the equivocal findings regarding the effect of women in the boardroom and firms financial position. Moreover, firms with a larger board size are less likely to experience financial distress as well. This adds to the inconclusive findings regarding the optimal board size. Also this finding could indicate that access to resources could be possibly more valuable than better monitoring. Furthermore, this research contributes to both firms and investors. In particular, when raising capital, investors will want to know about the business model, financial track record, but also they might want to hear about the view on corporate governance (Cohen, 2017). Moreover, the outcomes of this study will provide some insights into the importance of the different board characteristics and their quality on firm performance. In addition to this, possible failure could affect all the stakeholders; therefore it highlights the importance for stakeholders as well. Furthermore, it is important for investors to know which firms possess better future perspective.
The remainder of this thesis is structured in the following way. In chapter 2 a literature review is given and the hypotheses are formulated. Chapter 3 covers the research methodology, including the research method, sample selection, and operationalization of variables, empirical
models and the expectations regarding the association between the variables. The descriptive results and regression results are presented in chapter 4. Also, the results of the additional analysis performed in this study are given in the former chapter. Finally, chapter 5 shows the discussion and ends with a conclusion regarding the research question.
2 Literature review and hypothesis development
This literature section will provide a theoretical background to show what is already known about the different topics covered in this paper. Before being able to form an opinion about the effect of board characteristics and the likelihood of financial distress, it is necessary to understand how certain board characteristics could influence a firm’s financial position in a certain way. This relationship will be explained by the use of prior literature and certain developed theories concerning principal-agent problems. Finally the hypotheses will be formulated and substantiated.
2.1 Financial distress
“Corporate distress is a sobering economic reality reflecting the uniqueness of the American way of corporate
death” (Altman & Hotchkiss, 2006, p. 3). A firm can be seen as a financially distressed firm, when
for example the company fails to meet its debt obligations (Berk & DeMarzo, 2011). However, in order to avoid certain circumstances, firms have clear safeguards regarding the possible default risks. Corporate governance is one example of how firms safeguard themselves against financial distress (Manzaneque, Priego, & Merino, 2016). Corporate governance is separated in different mechanisms, however this thesis will focus solely on board characteristics.
The board of directors is liable for long-term decisions and their possibly ineffective work in monitoring and controlling management could affect companies’ performance (Hermalin & Weisbach, 2001). In general, the board of directors has fiduciary responsibilities, and when it comes to decision-making, decisions should always be done on behalf of all the shareholders. The board of directors is one mechanism in which firms can be safeguarded against financial irregularities.
Altman and Hotchkiss (2006) state that without questioning, the most pervasive reason for a firm’s distress and possible failure is some type of managerial incompetence. According to Altman and Hotchkiss firms fail for multiple reasons. However, they state that management inadequacies are at the ‘core’ of the problems. Some examples of managerial incompetence could be explained by the following situations (Kallunki & Pykkö, 2012): (a) managers being too overconfident, (b) when managers are too over-optimistic and (c) managers having the illusion of being in control. According to Kallunki and Pykkö, those characteristics could explain over indebtedness and credit default. This is explained by the fact that those attitudes affect consumption attitude and saving and borrowing decisions, which could consequently lead to the above stated financial distress.
Furthermore it is stated that default risk is not only caused due to insolvency, in addition it could also be explained by a combination of performance, earnings quality and corporate governance mechanisms (Chiang, Chung, & Huang, 2015).
When looking at the financial crisis of 2008, the main trigger for the emergence of this crisis was excessive risk-taking by corporate executives (Jiraporn & Lee, 2017). According to Jiraporn and Lee (2017), excessive risk-taking can be seen as a primary cause to get financially distressed. As a result, it is important to understand the nature of excessive risk-taking, to prevent or lessen the likelihood of another crisis in the future. According to previous literature it is believed that corporate governance could lessen excessive risk-taking by corporate executives (Armstrong & Vashishtha, 2012; Coles, Daniel, & Naveen, 2006; Dong, Wang, & Xie, 2010).
2.2 Different theories regarding corporate governance
Corporate governance is often analyzed around major theoretical frameworks. The most common are agency theories, stewardship theories, and resource dependence theories. Those will be subsequently discussed in order to gain better understanding of the relevance of this study.
2.2.1 Agency theory
For a better understanding of all of the concepts discussed in this paper, an underlying theory that is of high importance is the agency theory. This theory can be seen as the core of the relevance of this paper. Jensen and Meckling developed this theory and they stated the following (1976, p. 308):
“We define an agency relationship as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. If both parties to the relationship are utility maximizers there is a good reason to believe that the agent will not always act in the best interests of the principal.”
Agency theorists argue that there is an unavoidable conflict between parties, such as principles and agents (Jensen & Meckling, 1976). According to Jensen & Meckling (1976) agency theory assumes that an individual is self-interested and opportunistic, rather than altruistic. The second problem addressed by the theory refers to the different attitudes that principals and agents have towards risk, the tolerance of risk and the method of approaching to risky situations.
Conflicting interests can be specified in different ways. Linder and Foss (2015) provide three examples of conflicting interests: ‘conflict in outcome-type preferences’ (1), ‘conflict in risk preferences’ (2) and ‘conflict in time horizon’ (3). For each of the former they have provided
examples for better understanding, which will be subsequently discussed. The first conflict of interest relates to the fact that top managers may prefer ‘empire building’, consumption of perks, leisure time, and so on, instead of maximizing shareholder’s value. The conflict in risk preferences relates to the fact that managers and stakeholders differ in risk tolerance and risk strategy. The conflict of time horizon relates to the fact that managers plan to leave the firm within a few years, therefore neglecting the long-term stakeholders value.
According to the above, there are many forms of conflict of interests, which need to be mitigated. The interests of various groups (e.g. shareholders, stakeholders) should be protected or balanced. This protection and balancing of the conflicting interests between these groups is part of the system of corporate governance. A major structural mechanism to limit this managerial behavior is the board of directors, which will be discussed in section 2.3.
2.2.2 Stewardship theory
In contrast to the agency theory, Donaldson and Davis (1991) developed the stewardship theory. This theory holds an optimistic view of human (managerial) behavior. Donaldson and Davis argue that agents are not necessarily motivated by individual goals, in contrary to the agency theory. Rather they are trustworthy and will not misuse corporate resources and they are motivated to work. It is a theory that emphasizes that managers, left on their own, will act as responsible stewards of the assets they control, in contrast to the agency theory.
This theory is originated from other perceptions towards human beings (managers). Organizational role-holders can be perceived as persons who are motivated by a need to achieve, also it is expected that humans will gain intrinsic satisfaction when they perform successfully and in a fairly manner (Herzberg, Mausner, & Snyderman, 1959). It comes to the fact that an important motivating factor for managers is to get satisfaction from a job that is well done.
To conclude, the stewardship theory states that managerial behavior will be pro-organizational and in line with organization’s interests. Therefore this theory is in contrast with the agency theory as discussed in section 2.2.1.
2.2.3 Resource dependence theory
Another theory that is relevant for understanding certain corporate governance mechanisms and its importance is the resource dependence theory. The resource dependence theory is a theory developed by Pfeffer and Salancik in 1978, and ever since its publication it is widely used and referred to (Pfeffer & Salancik, 1978; Hillman, Withers, & Collens, Resource dependence theory: A review, 2009). The resource dependence theory, as stated by Pfeffer and Salancik (1978),
characterizes firms as open systems, which are reliant on contingencies in the external environment. Pfeffer and Salancik give four examples of external contingencies and refer to those as benefits. The first benefit they refer to is the provision of resources, and more specifically they refer to the provision of information and expertise. The second benefit is the creation of channels of communication with important constituents. The third benefit is the provision of commitments of support from important organizations or groups in the external environment. The fourth benefit is creation of legitimacy for the firm in the external environment.
To obtain external information, firms have boards; more specifically firms have boards with independent board members. Cowen and Marcel (2011) state that the board of directors has the formal responsibility to assist in gaining access to resources that the organization needs for successfully executing its operations. Different types of directors will provide beneficial resources to the firm. Consequently, more diversified boards will provide more valuable resources, which in turn will enhance firm performance (Hillman, Cannella, & Paetzold, 2000). The different types of directors will be discussed in the following paragraph.
2.3 Board characteristics
The scrutiny of the company’s board of directors and the emphasis of the financial aspects of corporate governance, was realized, for the first time, with the Cadbury Report in 1992 (Cadbury, 1992). This report includes recommendations regarding the arrangement of company boards and their accounting systems in order to mitigate corporate governance risks and possible failures. The Cadbury Report defines corporate governance as a system by which companies are directed and controlled. The definition provides the vital role that leaders in an organization have in establishing effective practices in order to control and direct the companies in a best way. For most companies, those leaders are the directors, since they decide the long-term strategy of the company in order to serve the best interests of all the stakeholders.
The board of directors is expected to align the interests of managers and shareholders and they always need to act in the best interest of the company. There are two types of directors: inside directors and outside directors. Outside directors serve only one role – to provide oversight on management – and are thus considered more objective, since they are not an employee or stakeholder to the company (Martin, 2011). Inside directors however, are considered to be less objective, since they receive meaningful stock-based compensation (Martin, 2011).
When a company might get financially distressed, the role of the board and the responsibilities of individual directors are transformed in important ways from what they were when the company was proceeding steadily (Rechden & Miller, 2015). For instance, shareholders and others expect the board to take a more proactive role than before and to put the company back on a course to financial health and profitability. These parties usually have the power to hold the directors legally accountable. Failure can result in unpleasant personal and professional consequences for directors.
Good corporate governance is best achieved by focusing on the accountability of the board of directors, it is even stated that this is the basis for the success of all other corporate governance mechanisms (Makuta, 2009). So, in order to get the optimal corporate governance structure, the first step in achieving this is to look at the board of directors.
The board of directors is one among many elements of corporate governance structure. Many researches have been conducted regarding corporate governance and its mechanisms (Manzaneque, Priego, & Merino, 2016; Chiang, Chung, & Huang, 2015). However, contradictory results indicate the importance of further research in this field. There are many board characteristics, however, this thesis will focus only on board independence, board size and board diversity. Those will be subsequently discussed.
2.3.1 Board independence
As aforementioned, one mechanism of corporate governance is the board of directors (John & Senbet, 1998). The board of directors has an important role in minimizing the costs arising from separation of ownership and control of firms. Even if the board would delegate decision rights and control to the top management, the board would still have final control over the top management (Fama & Jensen, 1983).
In 2003, the New York Stock Exchange and NASD revised their rules around corporate governance and required that boards should have a majority of independent members (SEC, 2003). Ever since, however, there has been a broad debate in the literature as to whether board independence adds value to firms, with no definitive conclusion reached thus far (Rashid, 2018). This debate relates to the fact that there are two opposing theories regarding agency problems and the effect of corporate governance on those problems. Those theories are explained in section 2.2.1 and 2.2.2. Agency theorists will argue that independent board members are needed, because of the idea that insiders will be self-interested and opportunistic, rather than altruistic.
Rashid (2018) also states that agency problems will be more prevalent when insiders rule the board. However, according to the stewardship theory this statement would be refuted.
Nonetheless, the effectiveness of monitoring by the board of directors is determined by both inside and outside board members. However, most studies support a positive relationship between independence and the board’s monitoring (Dahya, McConnell, & Travlos, 2002; John & Senbet, 1998; Klein, 2002) and its strategic advisory roles (Baysinger, Hoskisson, & Texas, 2000; Johnson, Hoskisson, & Hitt, 1993). Those findings will be carefully analyzed.
First, the involvement of inside board members will be discussed. Inside board members have an important role in the board, since they are able to obtain useful specific information regarding the company’s activities (Solomon, 2007). This specific information is gathered by inside board members through the internal monitoring process of subordinate managers in the organization. However this information might be useful and relevant for the decision-making process, the reliability of this information could be affected as a result of the high level of decision discretion of top managers involved. Therefore the advantage of having insider knowledge could affect the objectivity of the board of directors, which could endanger the interests of the shareholders (Williamson, 1984). According to Martin (2011), another reason why the independence of the board may be affected is due to the fact that inside directors receive meaningful stock-based compensation. He further indicates that outside members are considered to be more objective, since they are not an employee or stakeholder to the company.
A possible solution regarding the above mentioned agency problems, is the inclusion of outside board members (Fama & Jensen, 1983). Their role is to act as a mediator in resulting conflicts between managers. As found in many researches, the strength of the board is enhanced by the presence of outside board members, since they are more effective in the monitoring process of management (Dahya, McConnell, & Travlos, 2002; John & Senbet, 1998; Klein, 2002; Fama & Jensen, 1983). Independence of the board is enhanced as the number of outside members in the boards increase. Board independence can be seen as an indicator of the board’s ability regarding monitoring, disciplining and influencing the management. Active and informed independent board members prevent and discourage managers from enriching themselves (Baber, Liang, & Zhu, 2012). Furthermore, Fich and Shivdasani (2007) indicate that outside board members are more incentivized to provide objective and effective financial reporting oversight, compared to inside board members. This is due to the fact that outside board members are concerned regarding their reputation, since they do not want to lose directorships afterwards and still want to qualify for new directorships.
Sometimes managers engage in excessive risk taking, even if it is expected that managers will act in the best interest of shareholders, they either take too little risk or too much (Jiraporn & Lee, 2017). According to Ramly (2013) this excessive risk taking is reduced by the control of independent directors. They check this behavior and are not influenced by other factors, since they have no direct link to the organization. It is expected that independent board members will always perform in order to maximize shareholder wealth.
Contrary to previously published studies, Mirvis and Savitt (2015) demonstrated the fact that the independent directors evoke some corresponding costs as well. This is explained by the fact that the typical board of directors now includes a greater number of directors who lack detailed operational knowledge about the firms they serve, and a greater percentage of directors who lack firm-specific commitment to their companies and all their stakeholders. That is the danger of independent directors according to Mirvis and Savitt. This could endanger the performance of the firms and therefore lead to financial distress. Furthermore, Mirvis and Savitt state that when firms enter into financial distress, inside directors will be more incentivized to enliven the firm, due to faced risk of losing the job. However, this is in contrast with the finding of Fich and Shivdasani (2007) who argue that outside board members will be more incentivized, compared to inside board members, to enliven the firm.
Other research regarding the comparison between inside and outside directors is conducted by Harris and Raviv (2008), who suggest that shareholders value will be enhanced with an insider-controlled board, since outside board members will not be able to obtain full and completely accurate information. Inside directors will have relevant information to the decision-making process, which outside directors might acquire, at a cost, and therefore this would be less efficient according to Harris & Raviv (2008).
Prior literature examined the effect of board independence on firm performance, indicating mixed results between board independence and firm performance (Fuzi, Halim, & Julizaerma, 2016). However, there is limited research regarding board independence and its relationship to financial distress. Some researches indicate that there is a negative relationship between board independence and default risk (Manzaneque, Priego, & Merino, 2016; Chiang, Chung, & Huang, 2015).
2.3.2 Board size
2018). Jensen (1993) suggested that limiting the board size had high priority in modern industrial revolution. He argues that when boards consist of more than seven or eight people, the effectiveness of the boards would decline and those boards would be more difficult for the CEO to control. However, according to Lipton and Lorsch (1992), the perfect board size would consist of 10 seats. Nevertheless, keeping boards small could help firms improve their performance due to the fact that larger boards would suffer from coordination and communication problems; hence board effectiveness would decline (Guest, 2009; Coles, Daniel, & Naveen, 2008). Moreover, keeping boards smaller could lead to better cohesiveness within boards according to Paniagua et al. (2018). It is found that there is a positive association between group cohesion and firm performance (Evans & Dion, 2012). Furthermore, Paniagua et al. state that strategic management is affected when boards increase, since large boards limit the members’ ability to initiate strategic interactions (Goodstein, Gautam, & Boeker, 1994). Coles et al. (2008) give an explanation for the fact that performance will decrease when boards are bigger. Those are because of the fact that within larger boards, freeriding could occur. Or as they call it “social loafing”, indicating that individuals exert less effort to achieve a goal when they work in a group than when they work alone.
However, larger boards, with their collective expertise will be more capable of executing their duties and will equally abridge management control (Akhtaruddin, Hossain, Hossain, & Yao, 2009). Nevertheless, it is also found that it is more difficult to arrange board meetings, reach consensus, which in turn, would lead to slower and less-efficient decision making (Jensen, 1993). Similarly, although smaller boards might be better operators in healthy firms, since they experience less coordination and free-rider problems (Yermack, 1996), larger boards may be better in financially distressed firms. This is due to the fact that larger boards possess more business contracts that increase the probability of finding strategic alliances and partners that could help the firm to recover from distress (Brédart, 2014). In addition, according to the resource dependence theory, larger boards would have better access to resources. Also, Daily and Dalton (2001) state that potential investors may view larger boards as a signal of increased access to resources. Cowen and Marcel (2011) state that board of directors have the formal responsibility to assist in gaining access to resources that the organization needs for successfully executing its operations, therefore having a bigger board could ease the obtainment of resources. Kalsie and Shrivastav (2016) also support the resource dependency theory because they argument that larger boards will have directors from diverse backgrounds which possess different skill sets. Those different skills and mindsets will contribute to the decision-making process and strategic planning in the organization. According to Ali (2018) when firms are larger,
a larger board is better due to increased complexities as firms grow. A large board with directors having a range of expertise could help perform the different complicated tasks more efficiently, compared to a smaller board with less different skills.
Another interesting point is the influence of the size of the board on risk-taking of firms. Nakano and Nguyen (2012) state that due to the fact that in large boards decision-making is more difficult compared to smaller boards, those larger boards are associated with less risk-taking. According to this finding they state that when firms take less risky project, firms value could decrease, since risky firms are often associated with higher profits. Wang (2012) finds in his study that companies with small boards invest more heavily in risky assets. However, a less aggressive debt policy is executed compared to companies with large boards. Suggesting that small boards better represent shareholders’ interests.
2.3.3 Board diversity
One of the most important trends in U.S. boardrooms over the past two decades is a shift towards the inclusion of women (Carter, D'Souza, Simkins, & Simpson, 2010; Upadhyay & Hongchao, 2014). The recently mandatory quotas – in Europe, not in the U.S. – state that there should be a minimum percentage of women in the boardroom (Kirsch, 2018).
This thesis will focus on gender diversity as a measure of board diversity. How females could affect the board can be explained by the human capital theory and also the resource dependence
theory. The human capital theory is developed by Gary Becker (1964), and he made people the
central focus of economics. According to the human capital theory and the resource dependence theory as discussed in section 2.2.3, women, with their different characteristics compared to men, will bring more and different resources to boards which could enhance performance. Differences in gender results in directors having unique human capital (Terjesen, Sealy, & Singh, 2009). Women will bring different perspectives, experiences and networks to the board, are ready to discuss difficult issues, engage in independent thinking, and improve board communication (Adams & Ferreira, 2009; Huang, Yan, Fornaro, & Elshhat, 2011).
According to gender & social roles, men and women behave like the stereotypes and beliefs in line with the social role they occupy. When we look at women, women tend to be more communal. This behavior indicates that their behavior is more friendly, unselfish, concerned with other and emotionally expressive. According to Spence and Buckner (2000) men tend to be agentic, which implies more masterful, assertive, competitive and dominant behavior.
When women in a leadership position behave more masculine, it is not seen and evaluated the same way as when men act masculine in the same position. Men with masculine behavior are seen as good leaders, while women are seen as pushy. However, more women in the board allocate more effort to monitoring (Adams & Ferreira, 2009). According to Adams and Ferreira (2009) female presence on the board of directors increases the attendance to and frequency of board meetings, which in turn are seen as a strengthening factor of board power.
Several studies have also indicated the relation between risk-averse behaviors in investment decisions and have found that males have a greater tendency for risk-taking and overconfidence (Barber & Odean, 2001; Jianakopolos & Bernasek, 1998; Brooks & Zank, 2005). Further research has shown that firms with women in the board are involved in less earnings management practices (Lakhal, Aguir, Lakhal, & Malek, 2015; Gul, Srinidhi, & Tsui, 2011; Adams & Ferreira, 2009). These findings suggest that women are effective in their monitoring role and are considered as a crucial corporate governance device, it also confirms that women behave more ethically than men.
Nevertheless, prior literature shows mixed results regarding the inclusion of women in the board and the effect on firm performance (Carter, D'Souza, Simkins, & Simpson, 2010; Adams & Ferreira, 2009; Perryman, Fernando, & Tripathy, 2016). Indicating the importance of this study.
2.4 Hypothesis development
In this paragraph, hypotheses related to board independence, board size and board diversity will be developed by taking into consideration the previously stated literature and theories. The aforementioned characteristics will be used to make a consideration about the expected result of certain board characteristics on the likelihood of financial distress.
2.4.1 Board independence and the likelihood of financial distress
According to the agency theory and Rashid (2018), independent board members are indispensable, because of the idea that insiders will be self-interested and opportunistic, rather than altruistic. Moreover, they affect the objectivity of the board, endangering the interests of shareholders (Williamson, 1984). Furthermore, most studies support a positive relationship between independence and the board’s monitoring (Dahya, McConnell, & Travlos, 2002; John & Senbet, 1998; Klein, 2002) and its strategic advisory roles (Baysinger, Hoskisson, & Texas, 2000; Johnson, Hoskisson, & Hitt, 1993). Active and informed independent board members prevent and discourage managers from enriching themselves (Baber, Liang, & Zhu, 2012). In addition,
according to Fich and Shivdasani (2007) outside board members are concerned about their reputation, since their performance can be seen as a main factor to reach membership on other boards. According to this principle, it can also be stated that outside board members would be more incentivized to perform better.
Contrary to the above arguments in favor of board independence Mirvis and Savitt (2015) found that independent directors evoke corresponding costs, leading to a worsened financial position. Furthermore, Harris and Raviv (2008), revealed that firms can sometimes be better off with an insider-controlled board due to omission of full or completely accurate information. This can have an adverse effect on the board’s decisions, reducing shareholder value. However, according to Williamson (1984), inside information could be harmed by the fact that there is a lot of managerial discretion.
According to prior literature, some studies found a negative relationship between board independence and default risk (Manzaneque, Priego, & Merino, 2016; Chiang, Chung, & Huang, 2015). According to the above finding and the fact that Ramly (2013) states that excessive risk taking is a major cause to financial distress that could be reduced by the control of independent directors (Armstrong & Vashishtha, 2012; Coles, Daniel, & Naveen, 2006; Dong, Wang, & Xie, 2010), the following hypothesis is stated:
Ø 𝐇𝟏: S&P 1500 firms with a higher proportion of independent directors in the board have
less likelihood of financial distress.
2.4.2 Board size and the likelihood of financial distress
An important subject matter in the corporate governance literature is whether having more board members in the board increases corporate performance and lessens the likelihood to financial distress. It has been a debatable topic for many years now (Paniagua, Rivelles, & Sapena, 2018). Similarly, while smaller boards may be better in healthy firms, due to reduced coordination, communication and free-rider problems (Yermack, 1996; Coles, Daniel, & Naveen, 2008), larger boards may have more business contracts that increase the likelihood of finding strategic alliances or partners that allow the firm to emerge from distress, referring to the resource dependence theory (Brédart, 2014; Cowen & Marcel, 2011). Also, it is found that larger boards will have better access to resources, and therefore larger boards will be better at obtaining resources in times of need (Kalsie & Shrivastav, 2016; Cowen & Marcel, 2011; Daily & Dalton, 1994). Moreover, keeping boards smaller could lead to better cohesiveness within boards
according to Paniagua et al. (2018), which in turn would enhance firm performance (Evans & Dion, 2012). Also, when looking at the risk-taking behavior and the size of the board, Wang (2012) states that smaller boards exert a less aggressive debt policy compared to companies with large boards. Therefore better representing the shareholders’ interests.
Nevertheless the inconsistencies in the above findings, firms with larger boards clearly have higher agency costs and lower performance, indicating that the probability of default would be higher. Since the arguments in favor of a larger board size can be considered to be ex post instead of ex ante regarding the contribution to firm performance, the following hypothesis is stated:
Ø 𝐇𝟐: S&P 1500 firms with a smaller board size will have less likelihood of financial
distress.
2.4.3 Females in the board and the likelihood of financial distress
First of all, according to the human capital theory, it is stated that having a more diverse board would enhance performance (Terjesen, Sealy, & Singh, 2009; Becker, 1964). Women will bring different perspectives, experiences and networks to the board, are ready to discuss difficult issues, engage in independent thinking, and improve board communication (Adams & Ferreira, 2009; Huang, Yan, Fornaro, & Elshhat, 2011).
Prior literature indicated that males have greater propensity for risk-taking and overconfidence (Barber & Odean, 2001; Jianakopolos & Bernasek, 1998; Brooks & Zank, 2005). It is also found that women in the board are involved in less earnings management practices (Lakhal, Aguir, Lakhal, & Malek, 2015; Gul, Srinidhi, & Tsui, 2011; Adams & Ferreira, 2009). Female presence on the board of directors was reported to increase the attendance to and frequency of board meetings, which in turn are seen as a strengthening factor of board power. As stated in paragraph 2.1, earnings management and excessive risk taking can be seen as potential financial distress factors, hence, the following can be conceivably hypothesized:
Ø 𝐇𝟑: S&P 1500 firms with a higher proportion of women in the boardroom will have less
3 Data and method
This section outlines the methodology and research methods used to operationalize the dependent and independent variables, and hence to test the hypotheses. The first paragraph focuses on the sample selection. The second paragraph will give an explanation for the chosen variables; thereafter the research model will be given which will test the hypotheses.
3.1 Sample selection
In order to test the hypotheses as proposed, this thesis focuses on S&P 1500 firms and their board characteristics and financial characteristics starting from 2007 till 2016. The starting point 2007 is chosen because there is no earlier data on board characteristics available in the databases. The end point 2016 is chosen because it is the latest data that is available, and therefore it is the most recent data. Also, this period includes the financial crisis, which highlights an important moment in the worldwide economy that is still affecting the economy. The chosen sample is representative for the U.S. economy, since the S&P 1500 includes all stocks in the S&P 500, S&P 400, and S&P 600 (S&P Dow Jones Indices, 2018). This index covers 90% of the market capitalization of U.S. stocks. S&P standards are widely used by different investors.
The data is collected from two different databases within Wharton Research Data Services, namely Compustat and Institutional Shareholder Services (ISS). First, data about board characteristics of S&P 1500 firms is obtained from ISS - Directors. Afterwards, all the relevant financial metrics data is obtained from Compustat. Those two samples were matched together by merging them with the use of STATA. At the end the sample consists of 8,774 firms, which include all the relevant data. The sample selection procedure is explained in table 1.
TABLE 1: SAMPLE SELECTION PROCEDURE
Sample selection procedure No of Obs.
Original sample ISS Directors - data board characteristics 14,808
Duplicates deleted (299)
Final sample data board characteristics 14,509
Data lost during merging with Compustat data (5,735)
Final sample 8,774
Notes: this table provides the sample selection procedure for the variables of interest. The numbers in
3.2 Research design
To support the hypotheses in this study a logistic regression analysis will be used. The corresponding regression model will be given and an explanation of the variables will be given.
3.2.1 Regression model
The relationship between board characteristics and the likelihood of financial distress is tested with the following logistic regression model. The description of the variables is shown in table 2.
𝐼𝐶𝑅 = 𝛽!+ 𝛽!𝐵_𝐼𝑁𝐷𝐸𝑃 + 𝛽!𝐵_𝑆𝐼𝑍𝐸 + 𝛽!𝐹𝐸𝑀𝐴𝐿𝐸 + 𝛽!𝑅𝑂𝐴 + 𝛽!𝐿𝑂𝑆𝑆 + 𝛽!𝐿𝐸𝑉𝐸𝑅𝐴𝐺𝐸 + 𝛽!𝐹𝑆𝐼𝑍𝐸 + 𝛽!𝐺𝑅𝑂𝑊𝑇𝐻 + 𝜀
This is the main model that will be used in this study, which has been developed based on prior literature, with the addition of some new variables of interest (Salloum, Azoury, & Azzi, 2013; Manzaneque, Priego, & Merino, 2016). 𝐼𝐶𝑅 is the dependent variable and takes either a value of 0 or 11. To test the given formula, a logistic regression analysis will be used to answer the
research question. The logistic regression analysis is related to multiple regression analysis, but with a dichotomous dependent variable (Tabachnick & Fidell, 2007). According to Brédart (2014) a dichotomous dependent variable is commonly used for bankruptcy and financial distress models. A dichotomous dependent variable can take only two values and in this thesis it is expressed by a dummy variable, where dependent variable takes the value of “0” if a company is in distress according to the calculated ICR score, or takes the value “1”, which represents that the company is healthy.
3.2.2 Variable description
To gain further understanding of the stated formula in section 3.2.1, an explanation of the variables is needed. Those variables will be explained by the use of prior literature. A description of the variables is given in table 2.
TABLE 2: VARIABLE DESCRIPTION
Variable Definition Source
Dependent variable
ICR ICR measures the interest coverage. ICR takes a value of either 0 or 1. A ‘good’ ratio refers to a company that can pay enough funds to pay the interest expenses on outstanding debt. (1 = ICR ≥ 2.5, 0 = < 2.5).2
WRDS: Compustat
Independent variables
B_INDEP Board independence is determined as a percentage of
outside board members in relation to the total board members.
WRDS: ISS Directors
B_SIZE Board size is measured as the total amount of members
in the board.
WRDS: ISS Directors
FEMALE Gender diversity is calculated as the percentage of
women on the board of directors in relation to the total board members.
WRDS: ISS Directors
Control variables
FSIZE = Natural logarithm of total assets WRDS: Compustat
ROA = Return on assets (net income / total assets) WRDS: Compustat
LEVERAGE = Total Liabilities / Total Assets WRDS: Compustat
LOSS = Net income (Loss = 1, gain = 0) WRDS: Compustat
GROWTH = Growth rate in sales for the year t WRDS: Compustat
Notes: This table provides the variable descriptions of the variables of interest in this study. The first column
states the variable name; the second column gives a definition/description of the variable of interest. Finally, the third column describes where the data has been obtained. A further explanation regarding the independent variables can be found in section 3.2.2.2.
2 The benchmark of 2.5 is chosen because it is stated that an optimal interest coverage ratio starts from 2.5 (Dothan, 2006). According to Borad (2018) a ratio below 2.5 is a warning signal.
3.2.2.1 Dependent variable: Interest coverage ratio
The dependent variable of interest in this thesis is the interest coverage ratio. The interest coverage ratio or times-interest-earned ratio (TIE) is a ratio that is used to see whether a firm can be seen as a financially distressed firm, since it indicates how strong the operating income of a firm can cover its annual interest expenditures (Brigham & Houston, 2007, p. 110). As mentioned earlier (paragraph 2.1), firms using debt, always face the risk to default. Failure to fulfill interest obligation can lead to financial distress and even to a firm’s bankruptcy. In the creditor’s aspect, firms with a high interest coverage ratio can borrow capital easier than those without (Dothan, 2006). So, due to the fact that borrowing money is an effective way for companies to build its business, it comes with a cost, namely the interest that is payable monthly or per year, which could directly affect the company’s profitability.
To determine the interest coverage ratio, the following formula is used in this thesis:
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑎𝑡𝑖𝑜 = 𝐸𝐵𝐼𝑇 𝐴𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
An interest coverage ratio above or equal to 2.5 is seen as a ratio that is financially doing ‘good’ (Dothan, 2006). According to Dothan (2006) the company can generate enough funds to pay the interest expenses on outstanding debt. Also, Borad (2018) states that a ratio below 2.5 is an absolute warning signal. Therefore, a benchmark of 2.5 is chosen in this study.
3.2.2.2 Independent variables
This section discusses the several independent variables in this thesis that are of relevance in answering the research question. Those are the following: board independence, board size & gender diversity. Besides the independent variables stated above, this study uses a number of 5 control variables. These control variables will also be discussed in this section.
3.2.2.2.1 Board independence
Board independence is determined as the number of independent directors in the board compared to the total size of the board. This is the percentage of outside board members in relation to the total board members. The variable (B_INDEP) is constructed by the use of the following formula.
% 𝐼𝑛𝑑𝑒𝑝𝑒𝑛𝑑𝑒𝑛𝑡 𝑏𝑜𝑎𝑟𝑑 𝑚𝑒𝑚𝑏𝑒𝑟𝑠 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑖𝑛𝑑𝑒𝑝𝑒𝑛𝑑𝑒𝑛𝑡 𝑏𝑜𝑎𝑟𝑑 𝑚𝑒𝑚𝑏𝑒𝑟𝑠 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑡𝑜𝑡𝑎𝑙 𝑏𝑜𝑎𝑟𝑑 𝑏𝑜𝑎𝑟𝑑 𝑚𝑒𝑚𝑏𝑒𝑟𝑠
To obtain the required data considering the independent directors, the variable Board affiliation in used in the WRDS – ISS Directors database. With the use of STATA the amount is separated into independent, affiliated and N/A board members. Likewise, the total of independent board members are summed up with the use of STATA.
3.2.2.2.2 Board size
To measure board size, the number of board members will be used. The variable board size (B_SIZE) will be obtained from ISS – Directors, however this only gives the classification of the board members (affiliated, independent or N/A). To get the total board size, using a command in STATA will give the total number.
3.2.2.2.3 Females
To measure the amount of female board members (FEMALE), the total of women in the board is set out in percentage to the total board members. The following formula is used to obtain this amount:
% 𝐹𝐸𝑀𝐴𝐿𝐸𝑆 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑤𝑜𝑚𝑒𝑛 𝑖𝑛 𝑡ℎ𝑒 𝑏𝑜𝑎𝑟𝑑 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑡𝑜𝑡𝑎𝑙 𝑏𝑜𝑎𝑟𝑑 𝑚𝑒𝑚𝑏𝑒𝑟𝑠
To obtain the required data the database WRDS – ISS Directors is used. This database shows if there are females in the board with YES, otherwise it is blank. To count for the total amount of females in the board, STATA is used.
3.2.2.2.4 Control variables
Previous research has shown that different variables influence both the dependent variable and the main variables of interest in this research. These variables will be included in the empirical model as control variables, in order to ensure that those variables do not bias the results of this research.
First, return on assets (ROA) is included as control variable. ROA is a profitability measure. It is expected that a higher return on assets will have a negative effect on financial distress (Campbell, Hilscher, & Szilagyi, 2008).
The second control variable of interest is whether the net income of the firm was negative in the year of interest (LOSS). When firms experience periods of financial instability, or when firms report a loss this could be a warning to “abnormality of financial situation”, therefore this could potentially be a default risk factor (Wang & Deng, 2006). Moreover, when
firms report a loss, this increases transaction costs with different stakeholders, which in turn might lead to the fact that managers might try to avoid losses and engage in earnings management (Burgstahler & Dichev, 1997). Both of the former is expected to increase the likelihood of financial distress.
The third variable of interest is the amount of leverage (LEVERAGE). A firm’s leverage ratio is controlled for because firms with higher exposure to debt financing will probably suffer more during a financial crisis since their possibilities to raise extra capital will be limited and costly. Kristanti et al. (2016) state that the greater the leverage of the company, the greater the risk of probability to experience financial distress. Other researches found as well that the higher the leverage, the higher the probability of default would be (Ahmad, 2016; Elloumi & Gueyie, 2001). Therefore, it is necessary to control for leverage in this study.
The fourth control variable of interest is firm size (FSIZE). Firm size is defined as the natural logarithm of total assets. As firms become larger and more diversified. Firm size is taken as a proxy for the complexity of the firm and the need for higher amount of advice to the board (Fama & Jensen, 1983). The complexity of large firms would harm the relation between board characteristics and firm performance and therefore financial distress (Jensen & Meckling, 1976). Furthermore, larger firms are likely to have a higher proportion of capital held by outside parties. This could lead to more agency costs and therefore could increase the likelihood to financial distress (Watts & Zimmerman, 1990). Prior research found a positive influence between firm size and the possibility of financial distress and bankruptcy (Parker, Peters, & Turetsky, 2002).
Finally, the last control variable of interest is the sales growth rate (GROWTH). Companies with potentially high growth rates are considered to have most chance of growth in the future. Also, according to Thim et al. (2011) High growth firms should avoid issuing public debt, due to disclosure costs of revealing this information. Therefore it is expected that sales growth will have a negative relationship with financial distress.
Based on prior research and the above considerations, the study has selected firm size, leverage, loss, return on assets and sales growth as control variables to isolate the relationship between corporate governance (board characteristics) and financial distress.
4 Results
In this chapter the findings will be discussed, which emerged from the statistical analysis as presented in the previous chapter. The descriptive results and the regression results will be subsequently discussed. To support the reliability of the results, an additional analysis will be performed and those results will be discussed as well.
4.1 Descriptive statistics
Table 3 summarizes the financial characteristics of this initial sample. To control for outliers, winsorization is used, so no data was removed. With winsorization, the extreme small and large observations are set equal to the values of less extreme small and large observations, respectively. With winsorization, observations in the smallest percentile (1) are set equal to the smallest value of the 2nd percentile, while the observations in the largest percentile (100) equal to the largest
value of the 99th percentile.
As shown in table 3, the mean of (ICR) is around 80%, indicating that 80% of the sample takes a dummy value of 1, which indicates that more firms have an interest coverage ratio higher than 2.5. The mean of the percentage of (B_INDEP) is around 80%, which indicates that around 80% of the firms in this sample consist of outside directors. This finding is in contradiction with the finding of Manzaneque et al. (2016), as they find a percentage of 34%. The mean of (B_SIZE) is around 9, which shows equal results to the mean of board size of the research conducted by Lipton and Lorsch (1992) and Chiang et al. (2015). The mean of (FEMALE) is around 14%. This means that boards in this sample consist of 14% women. This is a relatively small amount.
TABLE 3: DESCRIPTIVE CHARACTERISTICS Descriptive characteristics full sample (N = 8,774)
Variables Mean St. dev Median Min p25 p75 Max
ICR 0.7976 0.4018 1.0000 0.0000 1.0000 1.0000 1.0000 B_INDEP 0.7915 0.1099 0.8182 0.0000 0.7143 0.8889 1.0000 B_SIZE 9.3411 2.2643 9.0000 3.0000 8.0000 11.0000 34.0000 FEMALE 0.1371 0.1028 0.1250 0.0000 0.0833 0.2000 0.7500 ROA 0.0464 0.0710 0.0472 -0.2627 0.0197 0.0814 0.2336 LOSS 0.1333 0.3400 0.0000 0.0000 0.0000 0.0000 1.0000 LEVERAGE 0.5540 0.1931 0.5554 0.1212 0.4256 0.6863 1.0332 FSIZE 8.1631 1.5786 8.0046 4.0936 7.0259 9.1319 14.4470 GROWTH 0.1843 0.6281 0.0364 -0.6597 -0.1309 0.2922 3.6537
Notes: the table provides summary statistics for firm-year observations from fiscal years 2007-2016. All numbers are
rounded up to fourth decimal place. Variable definitions are shown in table 2. The continuous variables are winsorized at the 1st and 99th percentiles.
4.2 Multicollinearity tests
Examining the correlations between the individual variables is an essential task before running the regressions. Correlations are a tool to gain understanding on whether the relation between two variables is positive or negative and to understand the strength of this (possible) relationship. The correlations that are executed in this thesis are the Pearson correlation table and the
spearman rank correlation test. One reason to use the Spearman rank correlation is to make sure that
the observed correlations are not driven by a few extreme observations or other nonlinearities in the data. The results of those two tests are shown in table 4.
TABLE 4: – CORRELATIONS Panel A: Pearson correlation table
ICR B_INDEP B_SIZE FEMALE ROA LOSS LEVERAGE FSIZE GROWTH
ICR 1.0000 B_INDEP 0.0525*** 1.0000 B_SIZE 0.0874*** 0.1659*** 1.0000 FEMALE 0.0836*** 0.2121*** 0.2527*** 1.0000 ROA 0.5059*** -0.0017 0.0477*** 0.0603*** 1.0000 LOSS -0.5108*** -0.0161 -0.0809*** -0.0608*** -0.6726*** 1.0000 LEVERAGE -0.1506*** 0.1797*** 0.2955*** 0.2297*** -0.1535*** 0.0425*** 1.0000 FSIZE 0.0104 0.2084*** 0.5655*** 0.2774*** 0.0122 -0.1128*** 0.4353*** 1.0000 GROWTH 0.0335** -0.0193* -0.0490*** -0.0323*** 0.0441*** -0.0312*** -0.0384*** 0.0056 1.0000
PANEL B: Spearman rank correlation table
ICR B_INDEP B_SIZE FEMALE ROA LOSS LEVERAGE FSIZE GROWTH
ICR 1.0000 B_INDEP 0.0639*** 1.0000 B_SIZE 0.0925*** 0.2586*** 1.0000 FEMALE 0.0785*** 0.2559*** 0.2735*** 1.0000 ROA 0.5432*** 0.0016 0.0248* 0.0392*** 1.0000 LOSS -0.5108*** -0.0232** -0.0878*** -0.057*** -0.5888*** 1.0000 LEVERAGE -0.1511*** 0.2097*** 0.3255*** 0.2332*** -0.2426*** 0.0377*** 1.0000 FSIZE -0.0008 0.2525*** 0.5891*** 0.2792*** -0.0487*** -0.1118*** 0.4456*** 1.0000 GROWTH 0.0913*** 0.0082 -0.0187* 0.0049 0.0829*** -0.0838*** -0.0154 0.0401*** 1.0000
Notes: This table reports the results for the main variables for firm-year observations from fiscal years 2007-2016. The sample consists of 8,774 S&P 1500 firms. All numbers are rounded up to fourth decimal place. Variable definitions are shown in section 3.2.
***. Correlation is significant at the 1% level **. Correlation is significant at the 5% level *. Correlation is significant at the 10% level.
When looking at the Pearson correlation test the following should be known first. The value of the Pearson correlation coefficient can vary between -1 and 1, where the value 1 indicates perfect positive linear relationship and the value of -1 a perfect negative linear relationship. If the Pearson coefficient has a value that is either too high or too low, it is expected to affect the reliability of the model in use. Therefore those variables should be excluded. A benchmark of a coefficient that is higher than .7 or lower than -.7 will be used in order to delete the variables, which affect the reliability of the model (Dancey & Reidy, 2004).
Table 4 shows that the independent variables are significantly correlated with the dependent variables. Also there’s significant correlation with most of the control variables with the independent variable, highlighting the importance of the chosen control variables in this thesis. When checking for the stated benchmark, all of the outcomes are acceptable, which confirms the reliability of the model.
4.3 Regression Analysis
This paragraph shows the results of the logistic regression analysis. The effect of board characteristics on financial distress is showed. More specifically, the results will indicate whether the stated hypotheses can be supported or whether they will be rejected.
Table 5 presents the results obtained after the application of the logistic regression analysis. 6 models are presented. In all of the regressions, the dependent variable is a binary variable and takes a value of 1 for an interest coverage ratio higher than 2.5, therefore indicating healthy financial position. In model 1, all the variables are included in the regression model. Therefore this model tests the effect of board characteristics on the likelihood of financial distress. In model 2 the effect of board independence on the likelihood of financial distress is tested. And therefore hypothesis 1 will be answered based on those results. In model 3, the effect of board size on the likelihood of financial distress is tested, whereas hypothesis 2 will be either accepted or rejected. In model 4, the effect of females in the board on the likelihood of financial distress is tested, resulting in an answer regarding hypothesis 3. Models 5 and 6 show the results regarding the interaction effect between the main variables of interest. Those tests and related results are additional. Furthermore, the marginal results are given in panel B for a better understanding of the logistic regression executed in this paper. The regression results can be found on the next page.
TABLE 5: LOGISTIC REGRESSION RESULTS + MARGINAL EFFECTS
Panel A: Logistic regression analysis Dependent variable =
ICR Model 1 Cf. Model 2 Cf. Model 3 Cf. Model 4 Cf. Model 5 Cf. Model 6 Cf.
B_INDEP 1.5949*** (0.3061) 2.0462*** (0.2949) - - 1.9719*** (0.3790) 1.3316*** (0.4651) B_SIZE 0.1574*** (0.0192) - 0.1802*** (0.0194) - 0.2255 (0.4831) -0.5293*** (0.0772) FEMALE 2.1736*** (0.3567) - - 2.8592*** (0.3545) 2.1918*** (0.3573) 0.3954 (2.294) B_INDEP*B_SIZE - - - - -0.9794 (0.6189) - B_INDEP*FEMALE - - - - - 2.3230 (2.921) ROA 20.3137*** (1.0692) 20.9945*** (1.0713) 20.5228*** (1.0709) 20.6908*** (1.0718) 20.4224*** (1.0690) 20.4500*** (1.0690) LOSS -0.9696*** (0.1175) -0.8775*** (0.1162) -0.9310*** (0.1170) -0.8924*** (0.1166) -0.9411*** (0.1175) -0.9366*** (0.1175) LEVERAGE -2.4432*** (0.2128) -2.1077*** (0.2080) -2.1881*** (0.2087) -2.2797*** (0.2113) -2.4323*** (0.2127) -2.4472*** (0.2129) FSIZE -0.1144*** (0.0257) 0.0219 (0.0238) -0.0834 (0.0274) 0.0103 (0.0240) -0.0662*** (0.0259) -0.0631** (0.0257) GROWTH 0.0920* (0.0533) 0.0482 (0.0530) 0.0817 (0.0538) 0.0627 (0.0529) 0.0871** (0.0534) 0.0871 (0.0533) Constant 0.3128 (0.2827) 0.3485 (0.2702) 1.2278 (0.1982) 1.7901 (0.1920) 1.2566*** (0.3426) 1.7332*** (0.4178) R² 0.3188 0.3048 0.3099 0.3072 0.3162 0.3160 N 8,774 8,774 8,774 8,774 8,774 8774 Prob > Chi ² 0.000 0.000 0.000 0.000 0.000 0.000
Panel B: Marginal Effects
B_INDEP 0.1823*** (0.0350) B_SIZE 0.0180*** (0.0022) FEMALE 0.2484*** (0.0406) ROA 2.3219*** (0.1131) LOSS -0.1108*** (0.0143) LEVERAGE -0.2793*** (0.0239) FSIZE -0.0131*** (0.0032) GROWTH 0.0105* (0.0061)
Notes: Panel A in this table shows the results of the effect of board characteristics on the likelihood of financial distress as
obtained through LOGIT regressions. ICR is used as dependent variable. The marginal results are given in Panel B. The sample consists of 8,774 S&P 1500 firms. All numbers are rounded up to fourth decimal place. Variable definitions are shown in section 3.2. The numbers in parentheses are the standard errors. The continuous variables are winsorized at the 1st and 99th percentile.
*** Indicate significance at the 1% level ** Indicate significance at the 5% level
