Can we predict the likelihood of financial distress in companies from their corporate governance and borrowing?

• Pages: 305-323
• DOI: https://doi.org/10.1108/IJAIM-08-2020-0130
• Date: 08 January 2021
• Published date: 08 January 2021
• Subject Matter: Accounting & finance,Accounting/accountancy,Accounting methods/systems
• Author: Sara Sofia Gomes Mariano,Javad Izadi,Maurice Pratt

Can we predict the likelihood of

f‌inancial distress in companies

from their corporate governance

and borrowing?

Sara Sofia Gomes Mariano and Javad Izadi

Claude Littner Business School, University of West London, London, UK, and

Maurice Pratt

University of West London, London, UK

Abstract

Purpose –The purpose of this studyis to investigate the impact of corporate governancestructures on the

likelihood of f‌inancial distress in UK listed companies. The paper examines the impact of borrowing and

corporategovernance structures on f‌inancial distress likelihoodin UK companies.

Design/methodology/approach –The study uses a quantitativeapproach with f‌inancial, governance

and borrowing measures and data from 270 f‌irm-observations between 2010 and 2018. The study analyses

the impact of borrowing and corporate governance structures to indicate f‌inancial distress likelihood in

British companies. Corporate governance variables such as ownership concentration, independence

indicators,chief executive off‌icer duality, director remunerationand corporate loans are considered, as well as

the UK CorporateGovernance Code.

Findings –The results indicate that companies with low ownership concentration and a low degree of

independence are more likely to incurf‌inancial distress. Larger boards and better director remuneration can

reduce f‌inancialdistress likelihood and the existence of corporateloans can increase this likelihood. Empirical

considerationof corporate borrowing is a new contribution to the literature.

Originality/value –Variables are highlighted and aggregated that have not otherwise been studied

together; the UK Corporate Governance Code’smain ideas are empirically supported; the study is useful for

def‌ining corporategovernance structure strategies.

Keywords Corporate governance, Financial distress, Corporate borrowing, Director remuneration

Paper type Research paper

1. Introduction

Financial distress and bankruptcy impact on companies and the business world every day

(Altman, 1968;Pindado et al.,2008;Manzaneque et al., 2016). Studying contributing factors

to that phenomenon is essential, Furthermore, understanding how corporate governance

affects f‌inancial distress should be a central tool, allowing better structures, more eff‌icient

operations, improving information transparency, safeguarding stakeholders and helping

mitigate risks.

Corporate borrowing and governance characteristics are enormously important in

studying company f‌inancial distress likelihood. The inf‌luence of corporate governance

structures on f‌inancial distress likelihood is studied, alongside the variables apparently

affecting this likelihood.

The relationship of corporate governance structures and borrowing with f‌inancial

distress likelihood in UK listed companies is a central question explored, applying a model

Corporate

governance

and borrowing

305

Received11 August 2020

Revised1 November 2020

Accepted22 November 2020

InternationalJournal of

Accounting& Information

Management

Vol.29 No. 2, 2021

pp. 305-323

© Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-08-2020-0130

The current issue and full text archive of this journal is available on Emerald Insight at:

https://www.emerald.com/insight/1834-7649.htm

with mainly corporate governance variables, to identify structures that may increase

f‌inancial distresslikelihood.

The UK Corporate Governance Code will additionally be considered. It concerns the

responsibilities of shareholders and directors and remuneration and independence of the

latter (FRC, 2018)[1].

Financial ratios are one of the most critical factors in predicting f‌inancial distress and

f‌irm performance (Manzaneque et al.,2016;Chen, 2008;Altman, 1968;Pindado et al.,2008).

The study’sf‌inancial distressmodel covers the main f‌inancial ratios of Pindado et al. (2008),

Altman (1968) and Ohlson (1980), alongside empirical studies of corporate governance

predicting f‌inancial distress. Variables such as ownership concentration, shareholder

independence, board size, chief executive off‌icer (CEO) duality, director remuneration and

corporate loans are considered, with their connection to agency theory, which will also be

considered.

Financial and corporate governance data from 270 UK listed companies across nine

years (2010–2018) is examinedwith half the companies exhibiting f‌inancial distressand half

being healthy. Evaluating the relationship between f‌inancial distress and corporate

governance, including variables denoting other characteristics apparently not analysed to

date, contributes to the existing literature. Corporate loans, director remuneration and

shareholder independence are focused on, complementing these with a study, and hence

support, of the UKCorporate Governance Code.

A main contribution is to present variables indicating strong corporate governance,

providing a guide to avoid f‌inancial problems of corrupt and weak company management

with poor corporate governance; exploring UK market characteristics further; and

deepening our understanding of how UK companies can increase the effectiveness of their

corporate governance and reduce bankruptcy likelihood. There is a lack of studies with

empirical evidence of the UK market with a direct approach to the UK Corporate

Governance Code.

We will show that ownership concentration, board size, independence of shareholders

and level of director remuneration are highly signif‌icant but negatively related with UK

company f‌inancial distress likelihood. In contrast, corporate loans appear closely linked to

f‌inancial distress: companies with corporate loans appear more likely to incur f‌inancial

distress.

2. Literature review

2.1 Corporate governance, f‌inancial distress and their relationship

Company performance has a direct relationship with corporate governance and how

companies are managed (Yu, 2011;Hodgson et al., 2011). Corporate governance is “the

system by which companies are directed and controlled”(Financial Reporting Council

(FRC)) in which managers and directors of companies (Handley-Schachler et al.,2007)

mainly implement that system.

Financial distressis associated with at least a company’s incapacity to pay obligations or

debt when due (Geng et al.,2015); f‌inancial debt is the main cause of f‌inancial distress or

default for Pham Vo Ninh et al. (2018).

Models have been createdto predict f‌inancial distress (Altman, 1968;Pindado et al.,2008;

Daily, 1996;Khoja et al.,2019;Kahl, 2002). They are useful to anticipate and understand

companies’f‌inancial signalsbefore a collapse or a recession period; so companies, investors,

creditors, regulators and stakeholders can better understand how to avoid a bankruptcy

situation throughthe application of important strategies and goodmanagement actions.

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