Use of Regression Analysis in Determining Impact of Financial Distress on Firm Value

Continuation from yesterday.

Now we have looked at different methods that could be adopted for estimating firm’s value. Today, we are going to look at the independent variables that could be used in measuring financial distress.

The first variable we would consider is the debt to equity ratio. This ratio measures the percent of the capital or the percentage of the company’s capital structure that is financed by debt. It indicates if the company have the capacity to fulfill it entire liabilities either short or long term. We would take an illustration to demonstrate how debt to equity ratio is calculated. Assuming company A’s total capital is N800M and out of that amount, N300M is debt and N500M is equity. In this case the debt to equity ratio is 38% (N300M/N800M). Higher debt to equity ratio indicates that company is highly geared – meaning, higher percentage of their operation is financed by debt while a lower number indicates that the company’s operation is financed by equity.

Second, interest coverage ratio. This ratio measure by how many times the company’s profit can cover the interest cost. A higher number indicate that the company have better cover against default. To calculate interest coverage ratio, we take interest cost and divide it by earnings before interest and tax. Many creditors expect the number to be high before they could agree to lend money to the company.

Third, net profit margin. This ratio measure how company is able to generate revenue over and above it cost. Companies’ performance is mostly measure by its profitability. A higher profitability margin indicates that company is more profitable compare to company with lower profitability margin. To measure company’s net profit margin, we divide net profit by total revenue.

Forth, Return on asset. Return on assets measure the percentage of profit earned by the total assets of the company. To generate sales, companies deploy its assets and the return on assets ratio measure how much profit each naira of assets generate. To calculate return on assets, we take the profit after interest and tax and divide it by the total assets employed. The higher the number, the higher the profit generate by the company.

The last variable to consider is the liquidity ratio. This ratio measure firm’s ability to pay-off its current liabilities using current assets. Higher liquidity ratio indicate that the company is highly liquid and can pay its liabilities when they fall due. A lower number indicate that the company might be at risk of defaulting on its current liabilities. To calculate liquidity ratio, we take the current assets and divide it by the current liabilities. Higher number indicates that the company can meet it debt obligation when they fall due using their current assets while a lower number indicates otherwise.

So, putting all the variables together, we could use regression analysis tool to analyse the data and determine the effects of each of the independent variable on the depended variables. In this case, how debt to equity, interest coverage, net profit margin, return on assets and liquidity ratio could impact firm’s value.