One of the major contributors to an economy is the industrial sectors of that country. In a growing economy, the industrial sector of a country can be thus portrayed as a major contributor to the GDP. Now, one of the major issues with the companies present within the industrial sector is financial distress which thy might face thereby affecting the overall growth of the economy in general. Financial distress represents that eminent condition in which a business organisation is not able to generate considerable amount of income or revenues or in certain circumstances are not able to effectively meet all of its liabilities within time (Dance and Imade 2019). This situation forces a business organisation to file for bankruptcy and consequently liquidate itself to pay off all dues owed to the outsiders. This situation of financial distress faced by companies within a growing economy, can be at times considered catastrophic for the growth of the economy itself. The Indian economy is one such growing economy possessing numerous big and small industries fighting for their subsistence and sustainable growth. This is why the prediction of financial difficulties concerning the companies present within the different business sectors of a growing economy like Indian economy, is a matter of urgent importance. If there is a timely estimation of financial distress faced by businesses within the growing economies can be done, then many different companies which may be facing financial distress can saved altogether from the issue of bankruptcy. On the other hand, it is to be noted that there are numerous well-known tools and techniques available in the field of finance to specifically measure this issue of financial distress, out of which the “financial ratio analysis” is one of the most tested and proved methods or tools. Lastly, it should be noted that there have not been many studies dedicated on identifying the financial distress faced by Indian companies using calculated financial ratios where many studies can be found on using already available secondary data. Therefore, the aim of this research is to identify the companies operating within the Indian economy which might be facing the financial distress using financial ratio analysis technique.
Liquid asset theory
The “Liquid asset theory” is one of the most important theories concerning financial distress which measures the condition of financial distress of a business through the relationship existing between the current liabilities and the net cash flows of a business organisation (Isayas 2021). If a firm have a positive cash flow, then it can borrow effectively from the market to enhance its business operations. While, on the other hand, if the business has a negative cash flow that is the net cash flow is lower as compared to the debt obligations of the firm, then the firm is expected to face the risk of default or is anticipated to be bankrupt.
Liquidity and profitability theory
According to Isayas (2021), the “Liquidity and profitability theory” portrays that if the profitability and liquidity conditions of a firm is good then in such a situation the particular business is said to be healthy. According to this theory, a healthy firm having a good profitability and liquidity position is less likely to face any issues of financial distress or bankruptcy and have a great potential for future growth. While, on the other hand, if a firm is not in a healthy state that is going through a bad profitability or liquidity situation, then there is more likely that the firm will default in near future relating to its payment obligations or may file for bankruptcy. So, the management of every firm is expected to measure the financial state and position of the business after regular intervals of time using well-known financial analysis tools such as the “financial ratio” through the use of which the firms can timely identify the financial distress situation if there is any and can make prudent business and economic decisions thereby saving the firm from running into financial bankruptcy.
Financial ratio which is also known by the name of “accounting ratio” portrays the “relative magnitude” of two quantitative values mainly extracted out of the financial statements published by any given business enterprise. Financial ratios provide analysed financial information about the profitability, efficiency, leverage and liquidity positions of a business enterprise based upon the pre-published data (Subalakshmi, Grahalakshmi and Manikandan 2018). Therefore, through “financial ratio analysis” one can easily identify the present position of liquidity, profitability, efficiency in operation and position of leverage concerning the business based upon which any given stakeholder can make effective and prudent investment and business decisions relating to the business entity in question. It is not all, the financial ratios provide an effective comparison of financial data concerning the four different positions as explained above relating to the business enterprise over a period of years. A financial analyst or any specific individual having a sound financial knowledge can effectively compare the results of the business over a period of time and can also compare the results of one business with that of another or with a wide range of firms operating in same or different industries across a same country or different countries thereby generating sound financial knowledge to guide a potential investor or any other relevant stakeholders of a company. The financial ratios can also be used by the management of any business for making certain strategic business decisions. The financial ratios can be prepared by an internal management of a business entity which can be effectively compared with the industry standards or averages as well as with the calculated ratios of the leading firm in the industry (Robinson 2020). This helps the management to identify the company’s present position in the industry through identification of certain weak points which if rectified can help the firm to grow immensely and effectively compete with the leading firm within the same industry. For instance, if the liquidity position of the firm is below the industry average specifically measured through the “Current ratio” and the “Quick ratio”, then the internal management may take few steps for improving the present state of current assets or reduce the current liabilities through certain strategic business decisions. This is how financial ratios help the management of a business in making certain strategic business decisions thereby enhancing the business performance and leading the firms towards a pre-determined and desired growth (Farfan et. al. 2017). Lastly, it can also be concluded that financial ratio analysis often serves as the tool for flagging warning signs for a business. The financial ratios can be utilised by a business to measure the performance over a period of time. Now, if it is found that the performance or profitability, or liquidity or efficiency is consistently falling over the years and may go below the industry average within a few years’ time. Then in such circumstances the financial ratio serves as the tool for provision of warning signs for the management to consider the matter of urgent importance and to make certain short-term or long business decisions which might restore the financial ratios to an earlier and acceptable limit. Therefore, on a concluding note, it can be said that the “financial ratio analysis” serves as a vital source for acquiring meaningful first-hand quantitatively analysed financial data concerning any given business enterprise (Robinson 2020). This is why the financial ratios are one of the most effective and efficient tools for carrying out a quantitative analysis on a company’s financials which are of utmost importance for all the different stakeholders of a company namely the lenders, shareholders, investors, creditors, management, employees, government agencies and the general; public at large.
Financial statements as known to everyone is of utmost importance to all related stakeholders of a business enterprise for which such financial statement analysis is being conducted. It is to be noted that there are many different well-established techniques to conduct the financial statement analysis such as “Horizontal analysis”, “Vertical analysis”, “Financial ratio analysis” and many more. However, according to Farfan et. al. (2017), out of these eminent methods or techniques of financial statement analysis, one of the most effective techniques for conducting a financial statement analysis is the “financial ratio analysis” which have its separate set of users that caters their specific financial information needs., which are as follows:
Management: The first eminent user of financial ratio analysis is the internal management of a business enterprise. This eminent stakeholder is referred to as one of the primary users of financial ratios in order to monitor the true performance and position of the business through a number eminent ratios such as profitability, efficiency, liquidity and leverage ratios based upon which they need to take eminent business decisions which may be categorised under short-term, medium-term and strategic decision making.
Creditors: The creditors are another stakeholder of a business who requires financial information in the form of ratios (Kimmel, Weygandt and Kieso 2020). This stakeholder mainly requires the financial ratios of liquidity and leverage such as “Current ratio” and “Debt-equity ratio” to see whether the business is having the capability to meet its short-term liabilities and to study the capital structure.
Lenders: The lenders are that specific stakeholder which provides the capital to a business organisation and hence requires first-hand information in the form of liquidity ratios, leverage ratios such as debt equity ratios and certain profitability ratios such as ROA, ROI, profit margin, Debt-equity ratios and many more just to see whether the bank is within a valid position to repay the debts and whether it is in a position to get more funds. The lenders also require the financial ratio information just as to check whether the business organisation is honouring the terms of the debt covenants or not.
Retail and institutional investors: Investors both retail and institutional also require financial information of the intended company before taking decisions concerning their future investments (Amalia, Fadjriah and Nugraha 2020). The investors are always in the lookout for the profitability and returns on their capital along with the capital structure and its trends concerning the company of their investment. This is why the investors are interested mainly on the profitability and leverage ratios.
Competitors: Competitors of a business organisation requires different first-hand financial information in the form of financial ratios for measuring the profitability and efficiency or at times the liquidity position of its competitors and hence this specific stakeholder of a business requires the financial data of a competitive business in the form of profitability, efficiency and liquidity ratios over a period of years.
Regulatory and government authorities: The regulatory or government agencies such as the stock exchanges and tax authorities requires financial ratios of a business mainly the profitability ratio. The other sub-parts of financial ratios namely efficiency, leverage and liquidity are also needed by the regulatory and government authorities to form a holistic view of the operations and efficiency of the business in question which might have a direct impact on the efficiency of operation and perpetual existence in the form of going concern of the business.
Financial analysts: The financial analysts represent those stakeholders of a business organisation who are not at all directly related to the business organisation and represents those persons who either work for different other businesses or on behalf of the individual or institutional investors, lenders or any other organisation who wants to carry out an impartial financial analysis of the business but do not possess the required financial intelligence, knowledge and competence (Kimmel, Weygandt and Kieso 2020). This is why those people or organisations hire such a professional financial analyst to carry out a professional financial analysis on their behalf based upon which these people or organisations makes a number of financial and economic decisions such as purchase and sales of shares, merger and acquisition, lending, providing goods on credit and many more. So, the financial analysts require all kinds of financial information in the form of financial ratios in order to assist their clients to make a prudent economic or investment decision. For instance, the financial analysts may conduct a liquidity, leverage and profitability analysis through analysing the liquidity, leverage and profitability ratios for creditors or lenders of a business while may conduct market value analysis for possible acquisitions and mergers through conduction of financial analysis of a business with the help of “market value ratios” such as “Book value per share ratio or Dividend yield ratio, EPS” or many more (Rashid 2018). This allows the relevant stakeholders of a business to make sound business and other economic decisions.
Owners and employees: The last relevant and direct stakeholders of any given business enterprise are its owners or shareholders and employees. These direct stakeholders require direct and first-hand information regarding the actual working, liquidity, leverage and profitability position of the business which have a direct impact on their present investment and future sustainability positions. The shareholders require first-hand financial information regarding the past workings of the business in the form of “Efficiency ratios” in order to evaluate the working of the executives hired by them to run the business entity on their behalf. Thus, a trend of the different efficiency ratios portrays how well the business has been working until now that is whether the efficiency of the management in managing the affairs of the business have literally enhanced over time or not or weather it has deteriorated over time (Amalia, Fadjriah and Nugraha 2020). This ratio may also be used by the owners to detect corporate fraud if there is any because in today’s corporate structure, the executive compensation especially the incentive part is greatly reliant and linked to the corporate performance which denotes the actual efficiency of these executive in managing the affairs of the business. So, the owners can easily compare the trend of corporate performance and profitability over time with that of the executive compensation paid and thus can comment on the fact whether there is any fraud being committed by the executives thereby enhancing their executive compensation without a real enhancement being noticed within the trend of corporate efficiency and profitability position over time (Kimmel, Weygandt and Kieso 2020). The employees of a business organisation also require financial information mainly in the form of financial ratios in order to check the profitability and liquidity position of the business in order to forma n opinion on the “going concern” ability of the business. This checking and forming an opinion on the going concern ability of the business will certainly give them an idea as to whether their job is secure or there may be a possible effective reduction of manpower owing to lack of ability of the business to continue as a “going concern” measures through bad and decreasing liquidity and profitability position especially in comparison to the industry standards and to the calculated ratios of its competitors. This also helps them to identify those businesses with better present and future prospects thereby assisting them in making effective and prudent choices concerning shifting of job or employment.
According to Alaminos and Fernández (2019), financial distress refers to such an economic condition faced by any business or non-business enterprise or by any individual person where such individual person or the business or non-business enterprise fails to generate enough financial resources mainly in the form of revenue or income to keep such an entity alive. This means that under a financial distress condition a business enterprise is not in a position to generate enough income for itself which can allow such a business entity to keep its operations alive that through paying all its liabilities in time and purchasing new assets or raw materials to keep the production or sales alive thereby regenerating the scope for future earnings. So, in simple sense, financial distress is said to be faced by any individual or business entity which has been suffering from the easy availability of capital or funds in general to keep its production, sales and scope for future earnings alive. According to Alaminos and Fernández (2019) and many other well-known scholars such as Dewi and Hadri (2017), there are many different reasons as to why a business enterprise faces such a situation of financial distress. However, the eminent reasons for financial distress faced by the business organisations firstly includes high degree of fixed and variable costs. It is to be noted that if a business enterprise has a high degree of fixed and variable cost or if such costs have enhanced rapidly over time, then the business entity may face surmounting issues regarding its liquidity position. This means that if the business has to pay a large amount of costs especially of fixed nature that cannot be avoided at all and such costs can be seen as enhancing over time, then the business may face difficulties in meeting all of its current liabilities in time. This is not all, if the business will not be in a position to meet all of its current liabilities in time then the credit worthiness of the business as well as its reputation among its suppliers and creditors falls which in turn affects the business’s production process as the suppliers are no longer willing to provide huge amounts of raw materials on credit or may be providing raw materials in limited quantities on credit and the business will thus be compelled to transact in cash which will have a direct impact on the working capital requirements of such a business thereby affecting its scope to generate future income thereby affecting its sustainability and going concern ability.
The second most eminent reasons for financial distress for any given business enterprise is the lack of proper availability of working capital to keep the business running in a sustainable way. According to Dewi and Hadri (2017), if a business organisation has an incapability to generate an optimum amount of working capital on a timely manner, then such a business may be subject to financial distress. This is because, working capital is the life source of any business enterprise as this capital is used to finance the business in its day-to-day operations after a capital investment is already made. Now, if such a capital source stand missing or is not available at optimum quantities or is not generated by the business as and when required then in such a case, the business will be facing serious financial crunch or financial distress which may affect the overall ability of the enterprise to sustainably operate as a going concern. The third most eminent and probable cause behind the financial distress faced by any business enterprise is the presence of large amount of “illiquid assets.” It is to be noted that if any business organisation has a presence of large quantities of “illiquid assets” such as fixed assets that cannot be readily sold at the market unlike cash or any other liquid assets, the business is most likely to face financial distress as it will not be having required funds to finance its day-to-day operations thereby keeping the business operations and scope for future earnings alive. The fourth eminent reason behind the financial distress faced by any business enterprise is the sensitiveness of the revenue generation abilities to the present prevailing economic conditions of the country or the industry in which the business organisation is operating (Mselmi, Lahiani and Hamza 2017). For instance, if the business has been manufacturing any kind of luxury goods and the present economic condition may be classified as “economic downturn” may be induced by spread of any pandemic disease, then in such a case, the business may lose its ability to generate probable future income which might affect the financial condition of such a business organisation and may force it towards financial distress. The last eminent cause behind the happening of financial distress is the mismanagement and fraud conducted by the executives trusted with management. It is to be noted here that if the top-level executives who are trusted by the owners of a business with the management of the business, conducts any kind of fraudulent activities or carry-out a mismanagement of all current and fixed assets just out of negligence or non-application of effective and due care, then the business may run into serious financial distress that might threaten the very existence of the business itself.
The aim of this study is to use the financial ratios in identifying the companies which might be facing financial difficulties in India. So, it is worth analysing the issue of financial distress faced by the companies that were operational or is operational within India. The first case which may be taken upon in understanding the issue of financial distress in India is the most recent case of “Jet Airways.” Jet Airways was considered as one of the most flourishing Indian-International aviation company that was known for its premium services. The company had recorded a total loss of over fifteen thousand crore Rupees over a period of ten financial years where it can be seen that the airlines have recorded loss in its last eight years’ out of ten years of operation (Ghosh 2020). There are may issues which was identified that caused serious financial distress for the airlines which ultimately forced the business to file for bankruptcy that includes mismanagement, rising and uncontrollable fixed and variable costs, lack of ability to generate profits over the years owing operational mismanagement and many more.
The financial distress of companies is one of the major issues that is faced by numerous economies around the world which have a direct impact on the holistic growth of that country’s GDP. So, an effective and timely prediction of the financial distress is one of the eminent aspects which is to be followed by all business organisation and by the relevant stakeholders of the business itself. This is how the business organisations likely to be facing the financial distress can be identified on a timely basis thereby allowing its management and the government authorities to take appropriate measures on a timely basis thereby allowing them to save such business and the economy in general. There have been numerous studies been conducted in this very field of financial distress prediction using a number of variables and tools such as financial ratios. However, all these studies were conducted in the context of different countries such as Indonesia and many more. But none of the studies were specifically dedicated to one of the fastest growing economies, India where there are quite a few existing cases of financial distress such as the case of “Jet Airways”, “Bhusan Steel”, “Essar Steel” and many more. This is where the research gap lies where the study has been specifically concentrated on the context of Indian companies which will effectively bridge the existing research gap.
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