Journal of Economics and Finance 9 Volume 23 9 Number2 ~ Summer 1999 9 Pages 123-I33

The Early Stages of Financial Distress

Richard B. Whitaker*

Abstract

More firms enter financial distress as a result of poor management

than as a result of economic distress. Management actions are a signif-
icant determinant of recovery and improvement in the industry-adjust-
ed market value for firms entering financial distress as a result of poor
management, but not for firms entering as a result of economic distress.
In the early stages of financial distress, median firm operating income
measured on an unadjusted basis and after controlling for other factors
which alter firm performance increases significantly. The results sup-
port Jensen's hypothesis that financial distress triggers corrective action
which improves firm performance. (JEL G300)

Introduction

Jensen (1989) argues that financial distress forces management to institute efficiency enhancing actions
which cause firm performance to improve. Firms enter financial distress as the result of economic distress,
a decline in the firm's industry, and poor management (Wruck 1990). Well managed firms which enter
financial distress as the result of industry declines would seem less likely to benefit from corrective man-
agement actions than would firms which enter financial distress due to the effects of poor management. The
relative significance of economic distress and poor management as causative factors for entry into financial
distress has not been established. Effectiveness of corrective management actions and the performance of
financially distressed firms may be, in part, a function of the cause of entry.
This paper examines the early stages of financial distress and the causes of firm entry into financial dis-
tress and provides a test of Jensen's hypothesis. Distinguishing between causes of entry, this paper evalu-
ates the determinants of firm recovery, the determinants of improvement in industry-adjusted market value,
and the changes in firm performance and firm market value during the early stages of financial distress.
Contrary to previous studies (Altman 1984; Opler and Titman 1994), this paper finds the net effect of
financial distress to be beneficial in its early stages and provides support for Jensen's hypothesis. Upon entry
into financial distress, management institutes efficiency-enhancing actions reversing a declining trend in
firm performance relative to the firm's industry.
More firms enter financial distress as the result of poor management rather than economic distress.
Management actions are a significant determinant of recovery and improvement in industry-adjusted market
value for firms that were historically poorly managed, but not for firms which entered financial distress as a
result of a decline in the firm's industry. Improvement in industry economic conditions is a significant deter-

* Richard B. Whitaker, Department of Finance, LumpkinCollege of Business, Eastern Illinois University, Charleston, Illinois
61920, cfrbwl@eiu.edu. This paper is based on my dissertation at the Universityof Houston. I appreciate the helpful commentsfrom
Ronald E Singer (chair), David W. Blackwell, Raul Susmel, and Julio Peixoto, and seminar participants at the Southern Finance
Associationmeeting.
124 JOURNAL OF ECONOMICS AND FINANCE 9 Volume 23 9 Number 2 ~ Summer 1999

minant of recovery for firms in economic distress, but not for firms which were historically poorly managed.
The paper is organized as follows. Section 2 describes the sample selection process and methodology.
Section 3 discusses the empirical results. Section 4 provides the conclusions of the paper.

S a m p l e Selection and M e t h o d o l o g y

Sample Selection

A commonly used proxy for financial distress is default, or the inability to meet contractual debt oblig-
ations as they come due (Baxter 1967; Brown, James, and Mooradian 1992; Ofek 1993). However, the
effects of financial distress are not limited to those firms which default but arise as the likelihood of default
increases.~ Potentially, a substantial portion of the effects of financial distress are incurred well prior to
default since much of the loss in firm value occurs during the years preceding default or bankruptcy rather
than after (Warner 1977; Clark and Weinstein 1983; Gilson, John, and Lang 1990).
This paper evaluates causes of entry into financial distress and firm performance during the early stages
o f financial distress. Entry into financial distress is defined as the first year in which cash flow is less than
current maturities of long-term debt. 2 Cash flow is defined as net income plus non-cash charges. Inadequate
cash flow is a necessary but not sufficient condition for payment default. As long as cash flow exceeds cur-
rent debt obligations, clearly, the firm has the funds available to pay its creditors. However, inadequate cash
flow to cover current debt obligations does not imply that the firm defaults. Firms have numerous options
to obtain the cash needed to avert default, including utilizing cash reserves, reducing inventory levels,
extending trade creditors, drawing upon bank lines of credit, restructuring debt payments prior to default,
raising equity, and selling assets. If inadequate cash flow continues, eventually these options are exhausted
and the firm defaults.
Market value is used as a selection criteria in order to assure that all firms in the sample are distressed.
During the distress year, all firms in the sample incurred either a decline in market value or a decline in
industry-adjusted market value. Industry-adjusted market value is the percentage change in firm market
value minus the percentage change in industry market value measured from the end of the pre-distress year
to the end of the distress year.
The sample consists of firms which entered financial distress during the years 1980-1992. Firms are
selected from the Compustat Industrial and Research tapes. In order to assure that the firms are selected in
the initial year of financial distress, firms are excluded from the sample if they reported cash flow inade-
quate to service debt during the previous five-year time period. Since industry performance is used as a
proxy for changes in economic conditions, firms are excluded from the sample if the Compustat tapes con-
tain less than four firms in the industry. The firm's industry is defined using the three-digit SIC code.
Industry variables are obtained by totalling the amounts for each firm on the Compustat Industrial tape with
the same three-digit SIC code. Firms in the financial sector (SIC 6000) are excluded from the sample.
The initial sample consists of 417 firms. Excluding those with less than four firms in the industry and
firms without complete data results in a sample of 326 firms. Excluding firms which did not incur either a
decline in market value or a decline in industry-adjusted market value results in a final sample of 267 firms.

t Altman (1984) states, "Indirect bankruptcy costs are not limited to firms which actually do fail. Firms that have high probabil-
ity of bankruptcy, whether they eventually fail or not, still can incur these costs."
Jensen and Meckling (1976) state, "In general, the revenues or the operating costs of the firm are not independent of the proba-
bility of bankruptcy and thus the capital structure of the firm. As the probability of bankruptcy increases, both the operating costs and
the revenues of the finn are adversely affected and some of these costs can be avoided by merger."
Warner (1977) states, "Baxter (1967) and Jensen and Meckling (1976) point out, for example, that a firm's sales and profits may
decline, and its market value fall when potential buyers of the product perceive default to be likely."
'-Wruck (1990) defines financial distress as cash flow insufficient to cover current obligations.
Asquith, Gertner, and Schaffstein (1994) define financial distress as EBITDAless than 80 percent of interest expense; however,
this definition does not incorporate scheduled principal reductions.
The Early Stages of Financial Distress 125

Methodology
Entry into financial distress suggests that firm performance has declined from previous levels. Firm per-
formance may decline because of economic distress, a decline in industry operating income, poor manage-
ment, or a decline in firm performance relative to the industry. Poor management is defined as a trend of
decline in firm operating income as a percentage of industry operating income measured over the preceding
five years.
The sample is divided into those firms which entered financial distress as the result of economic dis-
tress and those firms which entered financial distress as the result of poor management. Changes in firm per-
formance and determinants of firm recovery are determined for the full sample and each of the sub-samples.
Change in firm performance is determined on an unadjusted basis and after controlling for other factors
which alter performance. Change in firm performance is measured by the percentage change in operating
income in the distress year and immediately following year)

(FOI~ / FOIt.l) - 1 (1)

where
FOI = Firm Operating Income
t = 0,1 where 0 denotes the distress year

Operating income is defined as net sales minus costs of goods sold minus selling, general, and admin-
istrative expenses before depreciation and before gains or losses on asset sales. Change in operating income
captures much of the theorized effects of financial distress on firm performance.
Changes in economic conditions, asset sales, and the actions of management also may result in changes
in firm operating income. In order to separate the change in firm performance attributable to financial dis-
tress from that attributable to the change in industry economic conditions, the percentage change in indus-
try operating income is subtracted from the percentage change in firm operating income.

[(FOI, / FOIt.0 - 1] - [(IOI, / IOI,_t) - 1] (2)

where
IOI = Industry Operating Income

Financially distressed firms frequently undertake major asset divestitures to raise cash to satisfy creditor
demands or more efficiently structure the operations of the firm. Operating income as defined excludes gains
or losses from asset sales which could materially distort the measurement of firm performance. However,
asset divestitures eliminate a portion of the firm's operating income, introducing a downward bias in the
change in operating income from the distress year to the following year. Scaling operating income by year
end total assets adjusts for the effects of asset divestitures on operating income. Change in firm performance
after adjusting for changes in industry economic conditions and changes in firm asset size is computed by:

[(FOIt / FAt) / (FOIt_j / FAt.l) - 1] - [(IOIt / IAt) / (IOIt.~ / IAt_~) - 1] (3)

where
FA = Firm Book Value Total Assets
IA = Industry Book Value Total Assets

A finding that firm performance declines after controlling for industry economic conditions and asset
sales could not unambiguously be attributed to the effects of financial distress. A decline in firm perfor-
mance after the onset of financial distress could represent the continuation of a declining trend caused by
poor management that is unaltered by the onset of financial distress. Poor management is defined as sub-

3If operating income in the base year is negative,the variableis computed-(FOIt / FOIt. I - 1 ), resulting in the correct sign and
magnitude.
 126 Journal of Economics and Finance 9 Volume 23 9 Number 2 ~ Summer 1999

optimal management decisions unrelated to the effects of financial or economic distress. Poor management
is the inability of managers to evaluate or implement properly an optimal policy. This inability can be due
to inadequate internal controls, failure to obtain available information, poor organizational form, inadequate
personnel policies, inadequate decision-making process or criteria, or management incompetence.
If a firm is poorly managed or less well managed than other firms in its industry, then the performance
of the firm would decline relative to its industry. The effects of poor management would be evident in the
historic trend in performance of the firm relative to its industry. Poor management is proxied by the trend
in firm operating income relative to the industry over the five years preceding the measurement year.
Equation (3) is computed for each year beginning four years preceding the distress year and including the
distress year. The variable is regressed over time for years -4 through 0. Using the computed slope of the
trend line, the value of (3) is estimated for the year immediately following the onset of financial distress as
if firm performance had continued on the trend of the preceding five years. The estimated value for (3) rep-
resents the change in firm performance attributable to the effects of a trend of poor management after adjust-
ing for changes in economic conditions and firm asset size. The estimated value for (3) is subtracted from
the actual value for (3).

Actual (3) - Estimated (3) (4)

The result represents the change in firm performance after adjusting for changes in industry economic
conditions, firm asset size, and the historic trend in firm performance relative to its industry. The change in
firm performance, following the onset of financial distress and after controlling for other factors that alter
performance, is attributable to the onset of financial distress and represents the net costs or benefits of finan-
cial distress.
Change in firm market value of equity is determined on an unadjusted basis and after adjusting for
changes in industry market value.

FMVt / FMV,.~ - 1 (5)

[(FMVt / FMVt. ~) - 11 - [(IMV~/IMV,_t) - 1] (6)
where
FMV = Firm Market Value of Equity
IMV = Industry Market Value of Equity
t = 0,1 where 0 denotes the distress year

Recovery from financial distress is defined as cash flow greater than current maturities of long-term
debt in the year following the onset of financial distress. Jensen (1989) states that financial distress triggers
corrective action by management which improves firm performance. Studies have established that poorly
performing firms institute remedial action (John, Lang, and Netter 1992; Ofek 1993). However, it has not
been established that the actions taken are responsible for improvement in firm performance or recovery
from distress. Recovery from distress may be largely the result of improved economic conditions regardless
of any action taken by management. Firms with higher levels of financial distress are more likely to take
corrective action (Jensen 1989; Harris and Raviv 1990). However, firms with higher levels of financial dis-
tress are also less likely to recover. A logit regression determines the significance of management actions on
firm recovery when considered along with the contrary effects of economic distress and financial distress.
Improvement in industry-adjusted market value is defined as the percentage increase in firm market
value relative to the percentage increase in industry market value as measured from the pre-distress year to
the year following the firm's entry into financial distress. A positive value indicates the firm improved its
position relative to its industry following entry into financial distress. A Iogit regression determines the sig-
nificance of management actions on improvement in industry adjusted market value after controlling for the
severity of financial distress and changes in industry market value.
:]'heEarlyStagesof FinancialDistress 127

TABLE 1. REASONSFOR ENTRY INTO FINANCIALDISTRESS

Number Percentage

Both Economic Distress and Poor Management 100 37.5

Economic Distress Only 25 9.4
Poor Management Only 105 39.3
Neither Economic Distress or Poor Management 37 13.8

Notes:Table 1 reports the cause of the firm's entry into financial distress. Economicdistress is defined as a decline in industry oper-
ating income. Poor management is defined as a negative trend line of firm operating income/industry operating income measured over
a five-year time period.

Empirical Results
This section provides the results of the empirical tests which determine: 1) causes of firm entry into
financial distress, 2) the effect of financial distress on firm performance and firm market value, and 3) deter-
minants of firm recovery and determinants of improvement in firm market value relative to the industry.

Entry Into Financial Distress

Reasons for entry into financial distress are reported in Table 1. Seventy-seven percent of the firms were
poorly managed, reporting a trend of decline relative to their industries. 4 Forty-seven percent of the sample
firms were in economically distressed industries upon entry into financial distress. Thirty-eight percent of
the sample experienced both economic distress and poor management. Poor management represents the
more significant causative factor of entry into financial distress.

Change in Firm Performance and Firm Market Value Upon Entry Into Financial Distress

The change in firm performance in the first two years of financial distress is reported in Table 2. Firm
performance declines sharply in the distress year. A significant rebound occurs in the following year; how-
ever, firm performance remains well below the pre-distress level. Median firm operating income declines
47.09 percent in the year in which the firm enters financial distress and is 46.32 percent below industry per-
formance. In the following year, operating income rebounds with median growth of 29.49 percent. The
growth in median firm operating income is 13.42 percent greater than that of the firm's industry.
The decline in operating income for firms in economic distress is 59.86 percent, nearly double the
decline for firms not in economic distress. Both sub-groups report substantial improvements in performance
during the year following the firm's entry into financial distress. By the end of the following year, operat-
ing income of historically poorly managed firms is only 9.60 percent below the pre-distress level although
it remains 50.16 percent below the growth rate of its industry. For firms in economic distress, operating
income remains 42.95 percent below the pre-distress level and 31.02 percent below the growth rate of its
industry.

4Includingthe distress year, a year of known poor performance, in the calculation of the trend of firm performancerelative to its
industry biases the slope of the trend line downward. Excluding the distress year biases the slope of the trend line upward by exclud-
ing the effects of poor management during a year of known poor performance.
if the distress year is excluded from the computation of the trend line, the percentage of poorly managed firms is reduced from
77 percent to 56 percent. Improvementin median firm performanceadjusted for industry, size, and management from year 0 to year 1
is reduced from 46.15 percent to 42.66 percent. Other results reported in this paper are not affected.
128 JOURNAL OF ECONOMICSAND F1NANCE 9 Volume23 9 Number2 ~ Summer 1999

TABLE 2. MEDIAN PERCENTAGECHANGE IN FIRM OPERATINGINCOMEUPON ENTRY INTO FINANCIALDISTRESS

From To Unadjusted Industry Industry Industry, Size,

Year Year Adjusted and Size and Management
Adjusted Adjusted

Full Sample, N = 267

-1 0 -47.09** -46.32** -36.30** -

0 1 29.49** 13.42"* 28.29** 46.15"*
-1 1 -26.74**- -37.08** -11.37"* -

Firms Not In Economic Distress, N= 136

-1 0 -33.37** -56.31"* -36.97** -

0 1 25.70** 9.62** 24.20** 40.73**
-1 1 - 9.60* -50.16"* -15.11"* -

Firms h, Economic Distress, N= 131

-1 0 -59.86** -38.52** -34.51"*

0 1 46.93** 17.86"* 32.52** 55.93**
-1 1 -42.95** -31.02"* - 8.65**

Notes: Table 2 reports the percentage change in firm operating income measured (1) on an unadjusted basis, (2) after subtracting the
percentage change in industry operating income, (3) after adjusting for changes in industry operating income and firm size, and (4)
after adjusting for changes in industry operating income, firm size, and the historical trend in firm performance relative to its industry.
The year the firm entered financial distress is denoted as year 0. ** Significant at the one-percent level based on the sign rank test. *
Significant at the five-percent level based on the sign rank test.

Entry into financial distress reverses the historical trend of decline relative to the firm's industry. After
adjusting for the historic trend of firm performance relative to its industry and for changes in economic con-
ditions and firm size, firm performance increases 46.15 percent for the full sample. The improved operating
results in the year following entry into financial distress and the elimination of the downward trend attrib-
utable to poor management are consistent with Jensen's hypothesis that financial distress triggers corrective
action by management which improves firm performance.
The change in firm value in the first two years of financial distress is reported in Table 3. The median
decline in firm value during the distress year is 20.29 percent. In the following year, market value increas-
es 5.20 percent but remains well below the pre-distress level. The decline in industry-adjusted market value
is more pronounced. The median growth rate in firm value is 32.19 percent below that of the industry in the
distress year and is 46.76 percent below the industry two years after entry into financial distress. Although
firm operating income improves relative to the industry in the year following entry into financial distress,
growth in firm market value continues to lag behind the industry. The result suggests that the market takes
a longer term view and adopts a wait and see attitude regarding management responses to financial distress.

D e t e r m i n a n t s o f F i r m R e c o v e r y a n d I m p r o v e m e n t I n I n d u s t r y - A d j u s t e d M a r k e t Value

Recovery from financial distress is defined as cash flow sufficient to cover current maturities of long-
term debt in the year subsequent to the firm's entry into financial distress. One hundred sixty-three of the
sample firms recovered in the following year, and 104 of the firms remained in financial distress.
Recovery from financial distress is modeled as a function of the severity of financial distress, econom-
ic conditions, and actions of management. Financial leverage proxies for the severity of financial distress.
The Early Stages of Financial Distress 129

TABLE 3. MEDIAN PERCENTAGECHANGE IN FIRM MARKET

VALUE OF EQUITYUPON ENTRY INTO FINANCIALDISTRESS

From To Unadjusted Industry

Year Year Adjusted

Full Sample, N = 267

-1 0 -20.29** -32.19"*
0 1 5.20** - 9.72**
-1 1 -18.48"* -46.76**

Firms Not In Economic Distress, N= 136

-1 0 -17.78"* -35.86**
0 1 3.97 -13.01"*
-1 1 -18.17" -57.31"*

Firms hz Economic Distress, N= 131

-1 0 -23.57** -27.46**
0 1 8.14"* -3.54
-1 1 -18.48"* -37.96**

Notes: Table 3 reports the percentage change in firm market value of

equity measured(I) on an unadjusted basis and (2) after subtracting the
percentage change in industry operating income. The year the firm
entered financial distress is denoted as year 0. ** Significant at the one-
percentlevel based on the sign rank test. * Significant at the five-percent
level based on the sign rank test.

The percentage change in industry operating income proxies for the change in industry economic conditions.
The proxy for management action is selected on the basis that the variable is subject to managerial dis-
cretion and that previous studies have shown that the action is frequently taken by management. John, Lang,
and Netter (1992) and Ofek (1993) both found that poorly performing firms are likely to reduce the number
of employees. The percentage change in the ratio of employees/total assets proxies for management action.
Actions of management tend to be positively correlated. The change in employees/total assets is positively
correlated with the change in advertising/total assets (22.2 percent) and the change in R&D/total assets (35.9
percent) indicating the change in employees/total assets is a representative proxy for the actions of man-
agement. Firm size is included as a control variable. The independent variables are measured across the two-
year time period from the firm's entry into financial distress to the end of the following year.
A logit regression determines the factors which distinguish firms that recover from firms that do not
recover. The dependent variable is assigned a value of 1 if the firm recovers in the following year, and 0 oth-
erwise. The logit regression is specified as follows:

Recovery = a + b~ FINLEV. l + bz INDOI l.~ + b 3 EM/TA_~,I + b4 TA~.

where
FINLEV_I = book value of total liabilities/book value of total assets (at the end of the pre-distress year)
INDOI.I,j = [industry operating income (following year)/industry operating income (pre-distress year)] - 1
EM/TA_I,I = [number of employees/total assets (following year)/number of employees/total assets (pre-
distress year)]- 1
TA.I = log of total assets (at end of pre-distress year)
130 JOURNAL OF ECONOMICSAND FINANCE 9 Volume23 9 Number 2 ~ Summer 1999

TABLE 4. DESCRIPTIVE STATISTICS OF INDEPENDENT VARIABLES

Correlation Coefficients o f Independent Variables

Mean Median Finlev_t lndoi_l,l lndmv.l,l EmZFa. H Ta-i

Finlev i .560 .561 1.00 -.018 -.043 .035 .208

(.01) (.77) (.48) (.56) C01)

lndoi.l: .227 .152 -.018 1.00 .500 .122 -.056

(.77) (.01) (.01) (.05) (.36)

Indmvl: .427 .271 -.043 .500 1.00 -.014 -.193

(.48) (.01) (.01) (.81) (.01)

E n t / T a i,l -.037 -.061 .035 .122 -.014 1.00 .005

(.56) (.05) (.81) (.01) (.93)

Ta-i 5.946 5.846 .208 -.056 -. 193 .005 1.00

(.01) (.36) (.01) (.93) (.01)

Notes: Table 4 reports the means, medians, and correlation coefficients for the independent variables used in the logit regressions. Level
of statistical significance of the Spearman correlation coefficients is in parenthesis. Subscripts refer to the measurement year with the
distress year denoted as 0.

TABLE 5. DETERMINANTS OF RECOVERY FROM FINANCIAL DISTRESS

Full Sample Firms In Economic Distress Firms Not In Economic Distress

N = 267 N = 131 N = 136
Recovered = 163 Recovered = 69 Recovered = 94

Estimate X2 Estimate X2 Estimate X2

Intercept .189 .071 .995 .903 -.323 .089

Finley_ 1 -2.856 7.165"* -2.808 2.959 -3.878 6.349*
Indoi_l: 1.279 16.232"* 1.783 8.697** .787 3.155
Em/Ta_l: -1.271 3.913" -1.138 1.326 -1.776 3.982*
Ta_l .274 8.870** .125 1.140 .527 11.043"*

Notes: Recovery from financial distress is defined as cash flow greater than current maturities of long-term debt in the year following
the firm's entry into financial distress. Table 5 reports the results of a Iogit model with the dependent variable = 1 if the firm recovers
from financial distress, and 0 otherwise. P-values for all models = .0001. * Significant at the five-percent level. ** Significant at the
one-percent level.

The logit regression is applied to the full sample and to sub-samples consisting of those firms in eco-
nomic distress and those firms which were not in economic distress. The results are reported in Table 5.
Severity of financial distress is negatively correlated with recovery for the full sample and the sub-sample
of poorly managed firms. More highly leveraged firms are less likely to recover from financial distress in
the following year. The negative relationship between recovery and severity of financial distress is consis-
tent with the hypothesis that financial distress is associated with opportunity costs.
Improved economic conditions are a significant determinant of recovery for the full sample. Higher
growth in industry operating income is a significant factor in recovery if the firm's industry was in economic
The Early Stages of Fi~u~ncialDistress 131

TABLE 6. DETERMINANTS OF IMPROVEMENT IN INDUSTRY-ADJUSTED MARKET VALUE

Full Sample Firms In Economic Distress Firms Not In Economic Distress

N = 267 N = 131 N = 136
Improved = 42 Improved = 26 Improved = 16

Estimate X2 Estimate X2 Estimate X2

Intercept - 1.080 .866 - ,250 .026 -2.326 1.342

Finlev.~ -.703 .261 -1.162 .350 -1.041 .240
lndmv_t,t -1.446 10.140"* -,987 2.965 -2.393 6.874**
Em/Ta.l,l -1.841 4.225* -.897 .607 -3.625 5.484*
Ta_l .248 4.000* ,102 .505 .609 5.132"

Notes: Improvement in industry-adjusted market value is defined as percentage increase in firm market value of equity greater than the
percentage increase in industry market value of equity measured from the pre-distress year to the year following the firm's entry into
financial distress. Table 6 reports the results of a logit model with the dependent variable = 1 if industry-adjusted market value increas-
es, and 0 otherwise. P-values for the full sample and firms not in economic distress = .0001. The model for firms in economic distress
is not statistically significant. ** Significant at the one-percent level. * Significant at the five-percent level.

distress; however, industry performance is not a significant determinant of recovery if the firm entered
financial distress as a result of poor management rather than economic distress.
Greater reduction of the number of employees/total assets from the distress year to the following year is
associated with greater likelihood of recovery for the full sample. Efficiency-enhancing management actions
increase the probability of recovery only for firms that were historically poorly managed. Management
actions are not a significant factor in recovery if the firm entered financial distress due to economic condi-
tions in the industry.
Improvement in industry-adjusted market value is defined as the percentage increase in firm market
value of equity greater than the percentage increase in industry market value of equity measured from the
pre-distress year to the year following entry into financial distress. Since the sample firms are in financial
distress, it is not surprising that only 42 (15.7 percent) of the sample firms improved their positions relative
to their industries while 225 firms reported a decline in market value relative to their industries.
Improvement in industry-adjusted market value is modeled as a function of severity of financial dis-
tress, changes in industry market value, and management actions. A Iogit regression determines the signifi-
cance of management actions on improvement in industry-adjusted market value. The dependent variable is
assigned a value of 1 if firm market value increases relative to its industry, and 0 otherwise. The logit regres-
sion is specified as follows:

Improvement in Industry
= a + bl FINLEV-I + b2 INDMV-~,I + b3 EM/TA-H + b4 TA-~
Adjusted Market Value
where
INDMV ~,~ = [industry market value (following year) / industry market value (pre-distress year)] - 1

The logit regression is applied to the full sample and to sub-samples consisting of those firms in eco-
nomic distress and those firms which were not in economic distress. The results are reported in Table 6.
Corrective management actions are a significant determinant of improvement in industry adjusted market
value for the full sample and for the sub-sample of poorly managed firms. Management actions are not a
significant determinant of improvement in market value for firms which entered financial distress as a result
of decline in the industry. Severity of financial distress is not a significant factor in improvement in market
value relative to the industry. Higher growth in industry market value reduces the likelihood firm value
132 JOURNALOF ECONOMICSAND FINANCE 9 Volume23 9 Number2 , Summer1999

increases relative to the industry for the full sample and for the sub-sample of historically poorly managed
firms. Corrective management actions are a significant determinant of both recovery from financial distress
and improvement of firm market value relative to its industry.

Conclusion

The results provide support for Jensen's hypothesis that financial distress triggers corrective action by
management which improves firm performance. In the year following the firm's entry into financial distress,
firm performance and firm market value improve on average. Management actions are a significant deter-
minant of improvement in industry-adjusted market value and recovery from financial distress for firms
which historically had been poorly managed. Management actions are not a significant determinant for firms
which entered financial distress due to a decline in industry economic conditions.

References

Altman, Edward I. 1984. "A Further Empirical Investigation of the Bankruptcy Cost Question." Journal of
Finance 39: 1067-1089.
Asquith, Paul, Robert Gertner, and David Scharfstein. 1994. "Anatomy of Financial Distress: An
Examination of Junk Bond Issuers." Quarterly Journal of Economics 109: 625-658.
Brown, David T., Christopher M. James, and Robert M. Mooradian. 1992. "The Information Content of
Distressed Restructurings Involving Public and Private Debt Claims." Journal of Financial Economics
33: 93-118.
Clark, Truman A., and Mark I. Weinstein. 1983. "The Behavior of Common Stock of Bankrupt Firms."
Journal of Finance 38: 489-504.
Gilson, Stuart C., Kose John, and Larry H. P. Lang. 1990. "Troubled Debt Restructurings: An Empirical
Study of Private Reorganization of Firms in Default." Journal of Financial Economics 27: 315-353.
Harris, Milton, and Artur Raviv. 1990. "Capital Structure and Informational Role of Debt." Journal of
Finance 45:321-350.
Jensen, Michael C. 1989. "The Eclipse of the Public Corporation." Harvard Business Review 5: 61-74.
Jensen, Michael C., and William H. Meckling. 1976. "Theory of the Firm: Managerial Behavior, Agency
Costs and Ownership Structure." Journal of Financial Economics 3: 305-360.
John, Kose, Larry H. D. Lang, and Jeffry Netter. 1992. "The Voluntary Restructuring of Large Firms in
Response to Performance Decline." Journal of Finance 47: 891-917.
Ofek, Eli. 1993. "Capital Structure and Firm Response to Poor Performance." Journal of Financial
Economics 34: 3-30.
Opler, Tim C., and Sheridan Titman. "Financial Distress and Corporate Performance." Journal of Finance
49: 1015-1040.
Warner, Jerold B. 1977. "Bankruptcy Costs: Some Evidence." Journal of Finance 32: 337-347.
Wruck, Karen H. 1990. "Financial Distress, Reorganization, and Organizational Efficiency." Journal of
Financial Economics 27: 419-444.