Chapter 3: Corporate default risk modelling under distressed economic and
3.4 Empirical results
3.4.3 Discussion
87
0.3 98.40 1.97 0.00
0.4 98.40 1.97 0.00
0.5 96.90 1.97 7.69
0.6 96.90 1.97 7.69
0.7 95.30 1.97 15.38
0.8 93.20 1.97 25.64
0.9 93.20 0.00 33.33
Numerous studies have suggested several criteria for setting optimal cut-off points (see, for example, Sabela et al., 2018). In this study, cut-off points at which the sum of type 1 and type II error rates is minimal and the overall model performance is high are selected. In model I, the cut-off point of 0.3 has a minimal sum of the two errors of 30.32% (7.24% + 23.08%) and a model in-sample classification rate of 89.50%.
Therefore, a cut-off of 0.3 optimises model I. In the same vein, a cut-off point of 0.3 optimises models II and III. Model IV is optimised by cut-off points 0.3 and 0.4.
88 3.4.3.1 Model I
Table 3.7 provides the details of variables incorporated into model 1.
Table 3. 7 Model I results reflecting coefficient estimates
Variable Coefficient Wald Significance
BD/TA 2.869 17.325 0.000
STD/TA 1.667 11.576 0.001
EBIT/TA -3.760 8.082 0.004
(CA-CL)/TA -0.725 11.100 0.001
EBIT/TL 1.018 10.905 0.001
NS/NSLY 0.833 9.450 0.002
TwB -0.477 26.519 0.000
Constant 0.866 4.413 0.036
See Table 3.1 for ratio definitions.
The results show that all variables included in model I are significantly related to the default probability for Zimbabwean private firms, with the earnings before interest and tax/total assets ratio, the ratio of (current assets-current liabilities)/total assets and the time with the bank having a negative effect on the default probability, while the bank debt/total assets ratio, the ratio of short-term debt/total assets, the earnings before interest and tax/total liabilities ratio and the ratio of net sales/net sales last year having a positive effect on the default probability.
As a profitability measure, the earnings before interest and tax/total assets ratio has a negative sign, which is in line with that presented in the literature for public and private firms in both advanced and developing economies. This finding is not surprising given that high profitability increases the value of a corporate’s equity and indicates that a corporate needs more time for its costs to increase or revenues to fall before a default occurs. The negative correlation between profitability and the default probability has been associated with, among other countries, Austria (Hayden, 2011), the US (Ohlson, 1980; Shumway, 2001), Greece (Charalambakis, 2015) and India (Charalambakis and Garrett, 2016). Charalambakis and Garrett (2019) and Charalambakis (2014) revealed
89 that there is a negative relationship between profitability and the probability of financial distress for Greek privately-traded companies. Moreover, Altman, Sabato and Wilson (2010) and Altman and Sabato (2007) discovered a negative association between the probability of financial distress and profitability for small-to-medium enterprises (SMEs) in the United Kingdom (UK) and US, respectively.
It is observed that liquidity is a key measure of default risk. The ratio of (current assets- current liabilities)/total assets enters model I with a negative sign, as expected. Thus, liquidity considerably and negatively affects the default probability for Zimbabwean private firms, signifying that the more liquid they are, the less likely they are to default on their loans. Given that Zimbabwean private firms are operating in an illiquid market, high liquidity enables them to meet their short-term commitments. This discovery is in agreement with the findings of Altman, Sabato and Wilson (2010) for UK SMEs and Altman and Sabato (2007) for US SMEs. In addition, Charalambakis and Garrett (2019) and Charalambakis (2014) revealed a negative correlation between liquidity and the probability of financial distress for Greek private firms.
Time with the bank has a negative sign, expected. This means that loans of private firms with long-term lending relationships with their banks before loan acquisition are associated with low probability of default. Long-term firm-bank relationships are valuable to high-risk Zimbabwean private firms. Zimbabwean private firms with long- term relationships with banks are better able to withstand downturn conditions than firms with short-term relationships with banks. They are able to withstand downturn conditions because they benefit from reduced bank loan interest rates, low prices for services provided by the banks and from guarantees to get credit from banks even under distressed economic and financial conditions (banks usually lend to firms they knew before the emergence of strained economic and financial conditions). Assurance to get credit increases the availability of financial resources under illiquid conditions. Further, Zimbabwean private firms with long-term relationships with banks can renegotiate their credit conditions and can reduce the risk of information asymmetry, i.e., long-term relationships provide the bank with more information about the borrower than is often contained in financial statements. Congruent to this finding, Peltoniemi (2007) propounded that long-term firm-bank relationships are particularly valuable to high-risk corporates, and Petersen (1999) argued that a lending relationship between a corporate borrower and bank creates value to the borrowing firm in the form of assurance to get credit and low interest rates, among other benefits. Bodenhorn (2003) found that firms
90 with long-term firm-bank relationships benefit from lower costs of credit, fewer personal guarantees required when borrowing, and renegotiable loan terms during a credit crunch. Significantly, these authors indicated that firms with long-term firm-bank relationships are associated with low probability of default.
The study anticipates that leverage measures, the bank debt/total assets and short-term debt/total assets ratios have positive signs, which are consistent with those presented in the existent literature (see Brindescu-Olariu, 2016; Charalambakis, 2015, 2014; Hayden, 2011). Charalambakis and Garrett (2019) found a positive relationship between leverage and the probability of financial distress for Greek privately-traded companies.
Moreover, Altman, Sabato and Wilson (2010) and Altman and Sabato (2007) revealed a positive relationship between leverage and the probability of financial distress for UK and US SMEs, respectively. Zimbabwean private firms are often undercapitalised.
Hence, they use debt to finance growth and their working capital needs. However, the use of high leverage reduces their cover against adverse shocks, especially exogenous liquidity shocks. In the same vein, Falkenstein, Boral and Carty (2000) showed that as the gearing or leverage used by firms increases, the cushion against adverse shocks becomes smaller. Zimbabwean private firms that take on more debt under downturn conditions lead to higher rates of default because income must be used to pay back the debts even if earnings or cash flows go down. Moreover, credit comes at a cost that adversely affects customers' ability to repay debts (Aleksanyan and Huiban, 2016). Due to significant managerial errors resulting from inadequate or unsuitable industry experience and limited skills, Zimbabwean private firms fail to meet their obligations under distressed conditions.
The study does not have a prior expectation of either a positive or negative sign for the regression coefficient for the net sales/net sales last year ratio. In this study, it is noted that the correlation between default probability and the ratio of net sales/net sales last year is positive, indicating that, as the ratio increases, the default probability increases.
It is desirable, in practice, for a corporate to grow instead of scaling down. However, high sales growth is a major source of high default risk, as indicated here. Zimbabwean private firms have experienced phases of growth due to an increase in demand for local goods and services due to the introduction of “Buy Zimbabwe” and “Make Local Buy Local” campaigns by the government. Given that most Zimbabwean private firms are owned by the indigenous people with limited management abilities, the owners find it
91 difficult to cope with the management challenges that arise as a result of the rapid growth. Moreover, the rapid growth of sales has been financed through debt which is challenging to service for several Zimbabwean private firms due to continuous viability problems and their vulnerability to idiosyncratic shocks. Another possible explanation for the positive correlation between default probability and the ratio of net sales/net sales last year is that the sales growth has been driven by credit sales which turned into irrecoverable debts. Using the same line of reasoning, Hayden (2011) found a positive relationship between default probability for Austrian firms and the ratio of the net sales/net sales last year and argued that, in most cases, firms that expand very rapidly might fail to deal with the management difficulties that emerge as a result of swift growth. Falkenstein, Boral and Carty (2000) posited that high sales growth means that a firm is growing swiftly and that rapid growth is not likely to be financed by generated profits, leading to an increase in debt and other related risks such as bankruptcy.
In this study, the prior expectation is that the coefficient for the ratio of the earnings before interest and tax/total liabilities is negative. However, the study finds that the earnings before interest and tax/total liabilities ratio is associated with a positive regression coefficient, suggesting that the default probability rises as the ratio increases.
This finding goes against intuition, but the results are more driven by the denominator (total liabilities) than the numerator (earnings before interest and tax). Large levels of the ratio of earnings before interest and tax/total liabilities for Zimbabwean private firms result from low levels of total liabilities due to reduced levels of trade credit.
Several Zimbabwean private firms are of questionable creditworthiness and are embroiled in debt. Consequently, they cannot easily access formal credit from financial institutions. They depend more on trade credit from suppliers as a substitute for formal credit from financial institutions. However, financially distressed firms find it difficult to obtain trade credit from suppliers to maintain their sales. Even if they manage to access trade credit, its supply only lasts for a short time before the suppliers themselves become credit restricted and then decrease trade credit levels. Bastos and Pindado (2013) confirmed the substitution hypothesis between trade credit and bank credit in the context of a financial crisis. They concluded that suppliers offset credit shrinking from financial organizations when giving trade credit to less creditworthy companies. They further suggested that, during financial crises, suppliers grant trade credit for a short period before they become credit constrained and reduce trade credit level. Generally, due to the prevailing liquidity crisis, suppliers have restricted access to formal credit,
92 resulting in them having smaller cash holdings. This translates into reduced levels of trade credit to customer firms. In support of this, Shenoy and Williams (2017) indicated that suppliers with more access to bank liquidity provide more trade credit to their customers, and suppliers with less access to bank liquidity provide less trade credit to their customers. Such restrictions on trade credit push distressed firms into default, given that no other credit source is accessible to them.
3.4.3.2 Model II
Model II results are presented in Table 3.8.
Table 3. 8 Model II results reflecting coefficient estimates
Variable Coefficient Wald Significance
BD/TA 3.869 15.096 0.000
STD/TA 0.865 6.736 0.009
EBIT/TA -2.960 6.515 0.011
(CA-CL)/TA -1.011 15.097 0.000
EBIT/TL 2.977 18.406 0.000
CA/TA 0.275 10.454 0.001
NS/NSLY 0.964 6.133 0.013
TwB -0.297 14.440 0.000
Constant 2.855 18.452 0.000
See Table 3.1 for ratio definitions.
The experimental results show that all the variables included in model II are highly correlated with the default probability for Zimbabwean private firms, with the earnings before interest and tax/total assets ratio, the ratio of (current assets-current liabilities)/total assets and the time with the bank having a negative effect on the default probability, and the bank debt/total assets ratio, the ratio of short-term debt/total assets, the net sales/net sales last year ratio, the ratio of earnings before interest and tax/total liabilities and the ratio of current assets/total assets having a positive effect on the default probability. It is observed that the signs for the estimated coefficients for the bank debt/total assets, short-term debt/total assets, earnings before interest and tax/total assets, earnings before interest and tax/total liabilities, (current assets – current
93 liabilities)/total assets and net sales/net sales last year ratios and the time with the bank are similar to those in model I.
This experiment does not have a prior expectation of the positive sign for the coefficient for the ratio of current assets/total assets. The positive sign associated with the current assets/total assets ratio differs from the sign proposed in the literature (see, for example, Hayden 2011); it goes against intuition. Nevertheless, this result is more driven by the numerator (current assets) than the denominator (total assets). Due to the prolonged liquidity squeeze in the Zimbabwean currency system, several customers use trade credit, as they cannot buy goods on cash on delivery with restricted terms. As a result, several private firms have higher levels of accounts receivable, which they cannot amass quickly. This implies that private firms with high levels of accounts receivable also end up delaying or failing to make payments to their creditors, leading to a credit contagion cascading effect. Using the same line of reasoning, Bastos and Pindado (2013) suggested that trade credit contagion in the supply chain frequently happens during a financial crisis. Jorian and Zhang (2009) confirmed that trade credit interactions could spread credit contagion in industrial companies.
3.4.3.3 Model III
The regression coefficients for the predictor variables incorporated into model III are indicated in Table 3.9.
94 Table 3. 9 Model III results reflecting coefficient estimates
Variable Coefficient Wald Significance
BD/TA 1.035 4.159 0.041
AR/NS 2.150 14.612 0.000
EBIT/TA -2.623 15.812 0.000
(CA-CL)/TA -0.490 16.891 0.000
EBIT/TL 0.895 6.885 0.009
AG -1.648 11.742 0.001
RGDP -1.525 9.588 0.002
Constant 2.355 17.472 0.000
See Table 3.1 for ratio definitions.
The results show that all variables included in model III are significantly related to the default probability for Zimbabwean private firms, with the earnings before interest and tax/total assets ratio, the ratio of (current assets-current liabilities)/total assets, the age of the firm and the real GDP growth rate having a negative effect on probability of default, and the bank debt/total assets, accounts receivable/net sales and earnings before interest and tax/total liabilities ratios having a positive effect on probability of default. It is observed that the signs for the estimated coefficients for the bank debt/total assets, earnings before interest and tax/total assets, earnings before interest and tax/total liabilities and (current assets-current liabilities)/total assets ratios behave as in models I and II.
This study reveals that the real GDP growth rate is a significant determinant of the default probability for Zimbabwean private firms. The growth rate of real GDP enters model III with a negative sign, which is expected, indicating that the default probability decreases as the real GDP growth rate rises. This finding is not surprising, considering that an increase in the real GDP growth rate shows that the economy is performing well.
In agreement with this finding, Charalambakis and Garrett (2019) highlighted that the real GDP growth rate is negatively correlated with the probability of financial distress for Greek private firms.
95 Firm age dynamics have a significant influence on the mortality rates of Zimbabwean private firms. The coefficient for the age of the firm is statistically significant and has a negative sign, showing that young firms are associated with a higher risk of default than mature corporates. Youthful Zimbabwean private firms are faced with severe interior challenges and wrestle more with economic downturns and greater competition. In line with this finding, Succurro (2017) and Kenney, Cava and Rodgers (2016) suggested that young and adolescent firms are characterised by higher default risk than mature and established corporates due to several challenges, including stiff competition. However, this finding is not inconsistent with that of Switzer, Wang and Zhang (2018), who suggested that firm age and default risk are positively correlated.
The study finds that the accounts receivable/net sales ratio significantly and positively influences the default probability for Zimbabwean private firms, as expected, suggesting that probability of default rises as the ratio increases. This is in line with the findings of Hayden (2011), who proffered that the accounts receivable/net sales ratio substantially and positively influences the default probability for Austrian firms. Due to the liquidity crisis in Zimbabwe, several private firms have higher levels of accounts receivable due to the inability of customers to buy goods on restricted terms such as cash on delivery.
High levels of accounts receivable create default risk for the firms because they cannot be collected in time, thereby negatively affecting firm’s liquidity, profitability and cash flow positions. Moreover, an increase in accounts receivable leads to higher contagion risk from the default of debtors, resulting in credit losses to the creditors. These credit losses then drive the trade creditors into default and, subsequently, bankruptcy.
3.4.3.4 Model IV
The results for model IV are reported in Table 3.10.
96 Table 3. 10 Model IV results reflecting coefficient estimates
Variable Coefficient Wald Significance
BD/TA 1.487 9.373 0.002
AR/NS 1.257 8.342 0.004
EBIT/TA -0.617 7.290 0.007
(CA-CL)/TA -3.129 4.723 0.030
EBIT/TL 0.700 4.648 0.031
AG -0.563 27.521 0.000
RGDP -1.572 9.859 0.002
INF -0.239 9.842 0.002
Constant 0.818 5.406 0.020
See Table 3.1for ratio definitions.
The experimental results show that all the predictor variables included in model IV are significantly associated with the default probability for Zimbabwean private firms, with the earnings before interest and tax/total assets ratio, the ratio of (current assets-current liabilities)/total assets, the age of the firm, the real GDP growth rate and the inflation rate having a negative effect on the default probability, and the bank debt/total assets, accounts receivable/net sales and earnings before interest and tax/total liabilities ratios having a positive effect on the default probability. The study notes that the signs for the estimated coefficients for the bank debt/total assets, earnings before interest and tax/total assets, earnings before interest and tax/total liabilities, and (current assets- current liabilities)/total assets ratios behave as in models I and II. The real GDP growth rate and the firm's age enter model IV with a negative sign, while the accounts receivable/net sales ratio enters model IV with a positive sign, as in model III.
This study does not have a prior expectation of the negative sign for the coefficient for the inflation rate, which plainly goes against intuition. The coefficient for the inflation rate is significant and has a negative sign, revealing that, as the inflation rate increases, the default probability drops. Inflation benefits borrowers by reducing the real value of loans, thereby making it easier for them to pay their loans. Moreover, the observation period under consideration is characterised by deflation. Deflation leads to reduced
97 overall economic activity, a fall in investment, a rise in the real value of debt and an increase in the unemployment rate (see, for example, Mahonde, 2016). Masiyandima et al. (2018) argued that the emergence of the US dollar as the major currency in Zimbabwe led to negative and low rates of inflation, which impacted negatively on the country's growth. Deflation also aggravated the recession in Zimbabwe and led to a deflationary spiral. The rise in the real value of debts due to deflation makes it difficult for Zimbabwean private firms to repay outstanding loans, leading to high default rates.