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Essays on Financial Distress

  • Author(s): Ak, Baris Korcan
  • Advisor(s): Zhang, Xiao-Jun
  • Dechow, Patricia
  • et al.
Abstract

Financial statement analysis has been used to assess a company’s likelihood of financial distress - the probability that it will not be able to repay its debts. In the dissertation at hand, I provide two essays that add to the literature on the application of financial analysis to distressed firms.

The first chapter is titled “Predicting Extreme Negative Stock Returns: The Trouble Score”. This chapter examines the ability of accounting information to predict large negative stock returns. The Trouble Score addresses an important gap in the literature. Existing distress risk measures focus on predicting the most extreme negative events such as bankruptcy. However, such events are extremely rare and capture only the most financially distressed firms. There are many firms that experience financial distress but do not declare bankruptcy. By analyzing firms that experience a stock price decline of 50 percent or more, the T-Score enables researchers to capture extreme negative outcomes for corporate shareholders beyond commonly used financial distress measures such as bankruptcies and technical defaults.

The second chapter is titled “Relative Informativeness of Top Executives’ Trades in Financially Distressed Firms Compared to Financially Healthy Firms”. This chapter examines the informativeness of trades by top executives in firms experiencing varying levels of financial distress. Open-market transactions become differentially costly for the top executives of firms in financial distress. If insiders in a financially distressed firm buy the firm’s stock, they expose their financial capital and their human capital to the risks associated with the firm, thus making their trade differentially costly. It is conjectured that if the managers sell, they are subject to higher litigation risk. These differential costs increase the credibility and therefore the informativeness of the signal extracted from top executives’ trades in financially distressed firms. Consistent with this, I find that there is a positive association between top executives’ trades and future fundamental firm performance only in the presence of financial distress. In addition, these trades provide incremental information about the likelihood of survival over the existing distress risk measures. I find that the investors’ reaction to the disclosure of top executives’ purchases increases with the level of financial distress. The reaction is most negative following top executives’ sales in the most financially distressed firms. Finally, I show that there is a delay in the price reaction following top executives’ trades. A trading strategy that takes a long position in financially distressed firms in which insiders are net purchasers, earns future monthly abnormal profits of between 1.43 and 2.08 percent. This finding suggests that top executives’ trades reveal information that can be used to distinguish financially distressed firms that have good future prospects.

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