Exploring the Relationship between Financial Distress, Financial Flexibility, and Firm Performance: Empirical Evidence from Pakistan Stock Exchange

Abstract

Purpose– This main purpose of this paper is to empirically investigate the impact of corporate financial flexibility (FF) on financial distress and performance of firms listed on the Pakistan Stock Exchange (PSX). It enables to know how financial flexibility affects the firm financial strength, financial distress, and corporate performance. Design/methodology/approach –This study focuses on a firm level data of 192 non-financial firms covering the period 1992 - 2014. The fixed effect model logistic regression is applied by using unbalanced panel data to examine the impact of financial flexibility on financial distress, and performance of sample firms. Findings – The results reveal that financially flexible firms are less likely to face financial distress. As firms have more financial flexibility, the probability of financial distress decreases as well. It is also found that financially flexible firms are more likely to perform well than counterpart firms. By using the Altman z score as a measure of financial distress it is revealed that as the Altman z score increases, the chances of financial distress reduce as well. These findings also suggest the existence of pecking order in Pakistani firms; because firms rely on internal sources first, second go to external sources of financing. Practical implications – the findings of this study enable the corporate managers to avoid financial distress by obtaining and maintaining financial flexibility by keeping the leverage level lower than industry level. By attaining and maintaining financial flexibility, corporate managers can also raise the performance of the firm as well. It can also enable to make appropriate capital structure decision to finance managers of corporate firms. The creditors may provide the loan to sound firms who have no or least chances of financial distress. The lenders may also get benefit from it by requiring the interest rate as per risk of financial distress of the firm. Investors may avoid investing in firms having very little or no financial flexibility. JEL Classification– G33, L25 Keywords: Altman z score, financial flexibility, firm performance, return on asset, panel data, financial distress, modified z score.