Financial Conservative Policies and Financial Distress - Dissertation Example

?Investigate whether Financial Conservative Policies Depend on Financial Distress Table of Contents Table of Contents 2 3 Chapter Introduction 4 1.1 Research Aims and Objectives 4 Chapter 2 – Review of Literature 5 Chapter 3 – Theoretical Framework 9 Chapter 4 – Methodology and Data Collection 10 4.1 Data Collection Methods 13 Chapter 5 – Interpretation of Data 13 Chapter 6 – Conclusion 20 References 21 Deloitte (2009). ‘Financial conservatism’ [Online]. Available at http://www.deloitte.com/view/en_BE/be/insights/surveys/cfo-survey/q3-2009/6a3ec682d7895210VgnVCM200000bb42f00aRCRD.htm [Accessed: June 29, 2011]. 21 Bibliography 23 Gujarati, D. N. (2008) Basic Econometrics (4th Edition). New York, USA: McGraw-Hill. 23 Gravetter, F. J. & Wallnau, L. B. (2009) Statistics for the Behavioral Sciences. USA: Cengage. 23 Healey, J. F. (2009) The Essentials of Statistics: A Tool for Social Research. USA: Cengage. 23 A. Appendix 25 Abstract Financial conservatism is one of the most important reflectors of the financial state of a company. Ordinarily, such an attitude is adopted by companies which are either in financial distress or operate in a rather risky environment. Financial conservatism could be decomposed into cash conservatism and leverage conservatism each of which are again decided after taking into consideration a number of parameters. There typically is a debate about the degree of accuracy with which a financially distressed company is found to adopt financially conservative policies. The present paper takes up this subject and attempts to empirically analyze the same on the basis of around 950 USA firms, with data collected between 1998 and 2006. A panel data logit regression model had been set up firstly to assess cash conservatism, then leverage conservatism and finally financial conservatism. The conclusions to the research actually comply with the hypothesis framed earlier about the efficiency with which financial ratios could deduce the degree to which a firm adopts financially conservative policies. Chapter 1 – Introduction Financial conservatism is the attitude that the financial statements of many companies operating either in a risk prone environment or undergoing a tough financial phase, are found to adopt. These policies typically, reflect an environment where the companies are endowed with large cash balances and low leverage. While high cash balance indicates the presence of huge fund reserves to the company while, low leveraged financial structure implies that the concerned firm prefers turning towards equity financing over debt financing when they need funds for investment. However, maintaining such a stance might not necessarily mean that the concerned company is operating in a financially distressful environment. When firms find it difficult to meet their financial obligations to their creditors or fail to meet the same, they are considered as traversing through a phase of financial distress. But, financial conservatism might not imply that the firm in question is in a distressful phase of time; it might even mean that the entity is trying to shield itself against too much openness, which could land it up in a mess. However, one important factor which could be cited at this point is that financially conservative policies are highly transitory in nature. The present paper is targeted towards an examination of the extent to which financial conservatism is a suitable reflector of whether the company in question is literally amidst financially distressful phase or not. 1.1 Research Aims and Objectives The present paper attempts to assess whether firms which maintain a financially conservative policy are actually victims of financial distress or not. There is a high possibility of detecting a company’s financial situation through examining its financial policies. Empirically it had been found that in situations where a particular company is found to align to financially conservative policies over a considerable period of time, it generates some useful information to the potential investors of the company. Hence, the primary objective of the present paper will be to assess the extent to which the policies adopted by different companies actually have the power to transmit the true information to the enterprisers. In line with the research aims of the paper, one tentative hypothesis could be presented as the one to be examined in the present paper. This hypothesis being that financially conservative policies need not imply that the underlying firm is indeed undergoing a phase of financial distress. Chapter 2 – Review of Literature Financially conservative firms are characterized by high surplus of funds flow and relatively higher cash balance compared to other firms which go for a higher leverage. In most of the cases, these firms are found either to afford their investment expenditures by means of internal financing. In case that they need to incline towards external financing, they generally go for equity financing over debt financing techniques. However, such states are only temporary phases in the sense that firms do not tend to align to financially conservative policies for long, although question arises about the reason behind such a shift of focus over time (Minton & Wruck, 2001). It has been concluded from many researches that a low financial leverage and high cash balance often implies that the underlying firm is rather characterized by high growth opportunities. In addition, a correlation is found to exist between the ownership structure of the firm concerned and the degree of financial conservatism adopted by the company. For instance, firms are found to incline towards cash conservatism when more shares are held by the executive board of directors while leverage conservatism is displayed by the non-executive directors of the board. Moreover, the possibility of assuming conservative strategies is found to decline with a fall in the number of executive directors present in the board of the concerned company (Iona, Leonida & Ozkan, 2004). Many of the firms have been observed to prefer equity financing over debt financing in order to shove away the cost burden associated with the latter. In USA the corporate tax laws are quite conducive to the payment of taxes although many firms in the economy are found to give away with these benefits due to the immediate expenses associated with choosing debt financing over equity financing measures. This is primarily true for larger firms with highly profitable cost structures who find the marginal benefit of paying tax lower than shoving off the same as such a measure cannot add a significant amount to their already high profit figure. Moreover, these financially conservative firms have been empirically found to be choosing equity financing over debt financing in case that they cannot employ any method of exploiting internal funds, given that these firms normally maintain a high volume of financial stock. Quite contrary to widespread belief, these conservative firms, with a high profit structure, only give way to their stringent attitudes during short term crises. For instance, incidents of resignation by the CEO of such a company or unsuccessful investment ventures are associated with immediate increases in their financial leverage ratios and hence, a relaxation of their conservative structure (Lemmon & Zender, 2001). A regression analysis undergone upon 206 companies enlisted with the Karachi stock exchange yielded a negative association between profitability of firms and degree of aggressiveness in their working capital structures. The results indicate that more conservative the financial policies of the company, greater are the chances of the company making profit over the long run which definitely imply a robust financial structure. Hence, financial conservativeness did not mean that the firms under question are subject to financial distress (Afza & Nazir, 2007). A company is regarded as being struck by financial distress in situations when they find it difficult to meet their debt obligations or cannot meet the same at all, often leading to bankruptcy. As a chain of such events in Africa denoted, financial distress is generally the outcome of at least one of the following four instances – insider lending, lending out at high risk, instability in the macroeconomic environment and too high regulation. All the above four factors lead to too much of bad debts that finally lead a firm towards financial distress. The first factor out of the four is an outcome of corrupt practices while the second one occurs on account of inefficient financial decisions. The third factor is that owing to exogenous factors which cannot be made accountable to the negligence of the financial authorities or any biased behavior. The fourth factor is again on account of inefficient decisions being taken by the company (Brownbridge, 1998). If international experience is to be sought from global instances, it could be observed that the nations which had inclined to heavy borrowing during 1970s and 1980s were the ones which became victims of financial distress in the latter phase. This period could be trademarked by the occurrence of a number of adverse incidents ranging from the downfall of the Bretton-Woods Commission, huge deficits in current account, high fluctuations in oil price and fluctuations in the rate of interest (Hinds, 1988). For non-bank organizations, the commonest causes of financial distress are those arising out of performing below the expected level for a prolonged period of time. Such a behavior is owed to economic adversities, poorly designed product and service which spoil the potential market of the product, unrealistic plan of business or ill management for a considerable period of time (Moyer, 2005). A firm that is indulged in financial distress could easily be recognized through evaluating a few of its aspects which might also be identified as the potential indicators of financial distress. Some such indicators include trends in debt ratings, market prices and through estimating statistical models. Debts ratings imply the credit ratings which are issued by some affiliated organizations such as Standard and Poor’s, Fitch, etc. The poorer that the financial states of different companies become, lower gets these ratings. Being third party credit raters, their judgments are considered as unbiased and thus, could be relied upon. In most of the cases, these agencies make an analysis, which the investors look up to prior to making their investment decisions. Secondly, reference could be made to the predictive statistical models such as Z-score model to assess chances of a particular company getting bankrupt in near future. The model takes into account a number of financial ratios being calculated for a considerable period of time and hence, evaluates the firm’s future. Lastly, a sure indicator of financial distress could be the trends in the market price of the stocks of the particular company. For instance, lower that the market prices go, worse is the financial situation of the firm anticipated to be. Investors are believed to be huge followers of herd behavior and a clear example of the same could be sought from the way that the demand for stocks of a particular company is hampered after a series of price curtails (Moyer, 2005). The variables to be used in the Z-score model have often been researched upon. One of them found that the elements which could best estimate the financial state of a company include two aspects of corporate governance and seven financial ratios. Gross profit margin, return on assets and ratios deciding corporate governance features are some of the most important factors in this aspect. These indicators being zeroed upon through a grey analysis had been found to be ones with high power of prediction. In fact, the accuracy if the model so established is such that it could predict the financial situation of the electronic industry of Taiwan with least degree of error, for the year that the financial crisis struck the economy (Hsieh, Wang & Lu, 2006). On the other hand, there are a number of instances when financial fragility or distress that the companies are perturbed by, are accountable to the extent of macroeconomic instability that the company is operating in. Such instability instigates the company to indulge into debts which have to be met at some point of time. In order to meet these obligations thus, the concerned company needs to curtail its other expenses and implement conservative policies (Evans, Leone, Gill & Hilbers, 2000). However predictive models aimed at assessing the reasons behind financial distress confronted by banks show that in most of the cases, they are subject to problems arising out of macroeconomic instability. In addition, when the banks start relying upon external debts for reviving their financial situations, the problem of financial distress worsens, as had empirically been found for a handful of countries in Africa (Hardy & Pazarbasioglu, 1999). In fact, a similar conclusion could be drawn from the experience of Deloitte which shifted to financial conservatism soon after the period of financial crisis. The company focused its attention more towards acquiring or retaining high levels of cash and low degree of leverage as a result. Till date, the company has aligned itself to such financial strategies with more emphasis being laid upon equity financing rather than on borrowings to credit new investment ventures. Such sort of behavior is what had been observed among most of the firms based in UK over two years past the recession; debt financing has lost much in terms of popularity, to equity financing (Deloitte, 2009). On the other hand there are instances as well when the rationales behind adopting financially conservative strategies are accountable to the socio-political environment of the background nation. In common law nations, the extent to which the companies adopt financial conservatism depends upon the degree of intervention of the state. For instance, higher the degree of interference, lower will be the conservatism being adopted and vice versa. In civil law nations, in contrast, greater the involvement of the state, higher will be the degree of conservatism being adopted. Hence, there are various reasons behind the degree of financial conservatism that the companies adopt. The present paper attempts to assess the extent to which the firms in USA that are characterized by financial conservatism, actually bent towards such a policy owing to financial distress. Chapter 3 – Theoretical Framework Financial conservatism is one of the most obvious of ways through which organizations around the world take care of their financial crises in most of the cases. The concept has gained popularity over the years with globalization knocking at the threshold of almost every economy around the world. In most of the cases today, conservative strategies are adopted as a protection against macroeconomic fluctuations rather than to revive from the injuries caused by a past shock. It is often viewed to be similar with that of personal solvency where the firm as an entity strives to protect its positions midst fluctuations in the economy (Sen, 1999). Financial conservatism is often regarded as a measure to smoothen cost and benefits considerations. It could more be related to that of a trial and error process that has evolved over years in response to cost and benefit considerations. One of the most obvious of steps being followed in order to stay financially conservative is to overstate the asset figures and understate the liability values and delay the gain values intentionally. One of the primary reasons why such a step is usually followed is that it helps in lowering the expectations of their investors. In most of the cases, companies issue anticipated results on the basis of which their investors count upon their expected flow of dividends. But in case that the firm defaults to make such payments, the investors might be creating a lot of ruckus. In order to avoid such circumstances, the firms prefer not to be too stringent and rather adhere to conservative policies (Pratt, 2010). However, not all firms abide by such policies. In simple words, it depends upon the degree of risks that the company is operating in. In case that the environment is characterized by high risk, normally, the firm concedes to financially conservative policies (Kramer & Johnson, 2009). Adopting such financially conservative policies might result to a contraction of the economy as a whole however. In most of the cases, financially conservative policies are implemented by those companies which have a good brand name in the market so that issuing their financial details wrongfully might not make a huge difference in the sense that potential investors might not be much affected by the same. Instead if the smaller firms are found to be employing similar methods, they might turn out to be losers ultimately as potential investors stay highly aware of the financial details of new entrants in the market. In many cases it is found that when most of the big brand names adopt financially conservative policies, the potential investors do not even care to glance at the financial details of smaller but promising companies; they simply consider the market conditions to be unfavorable for investment and hence, back off (Kaufman, 2000). Such a situation was found to exist in Germany soon after the World War II when the economy had been in trouble. German companies adopted the strategy of retaining a significant proportion of their income as savings rather than for future investment ventures. Such a measure had been adopted to shield themselves against any unprecedented crises in the future (Nees, 2004). Chapter 4 – Methodology and Data Collection The financial data being collected for each of the firms will be used to examine the robustness of their fundamentals not as well as to assess whether the concerned firms have adapted to conservative policies or not. The next step will be to frame a model consisting of nine sets of regression models containing two equations, in the following form – CASHi = ?0 + ?1CFLOWi + ?2LIQi + ?3LEVi + ?4MTOOKi + ?5CAPEXi + ?6LOGASSi + ?i …(1) LEVi = ?0 + ?1TANGIBLEi + ?2MTOOKi + ?3CASHi + ?4PROFITi + ?5LOGASSi + ?i … (2) ‘CASH’ and ‘LEV’ are the required dependent variables given that the regression equations target at assessing the extent to which the explanatory variables, which essentially represent the financial state of a company, could actually explain variations in the cash balance and financial leverage of the same. Choices of dependent variables have been made in order to represent the financial conservativeness of any given company. After predicting the above regression equations, the next step will be to evaluate the predicted values of the dependent variables in either case. These are the figures of cash balance and financial leverage of the sample of firms which are completely explained by the regressors being chosen. However, if the observed values of the dependent variables are found to deviate from the estimated ones, it gives a hint towards the degree of conservatism followed by the particular firm. But this is not the only method to be used in order to assess the extent to which the firms adopt conservative policies. In order to represent the cash conservative, leverage conservative or financial conservative nature of a firm, use of dummy variables are made as follows – D = 1, if firm is conservative in nature and 0, otherwise Hence, there will be in all 3 sets of dummies in three equations attempting to examine the presence of cash conservatism, leverage conservatism or financial conservatism. Different methods will be adopted to assess the degree of conservatism, in each of the three cases and they have been illustrated as follows – Cash Conservatism There will be two models in all which are used to assess the degree of cash conservatism and the line of reasoning to be followed have been depicted as follows. (A) D = 1, when cash-holdings to total assets ratio is higher than 0.25 and 0, otherwise (B) D = 1, if cash balance ratio is found to be greater than its target level and 0, otherwise Leverage Conservatism The two models based on which the degree of leverage conservatism are to be decided, have been depicted as follows – (A) D = 1, when leverage ratio falls within the first 20% of the leverage distribution and 0, otherwise (B) D = 1, if leverage ratio is found to be greater than its target level and 0, otherwise Financial Conservatism (A) D = 1, when cash-holdings to total assets ratio is higher than 0.25 and leverage ratio falls within the first 20% of the leverage distribution 0, otherwise (B) D = 1, when cash balance ratio is found to be greater than its target level and leverage ratio is found to be greater than its target level 0, otherwise While the rationale behind framing Model (A) in all three cases is quite clearly an arbitrary one, that for Model (B) needs some degree of explanation. Model B regards those firms to be conservative which are corresponded by their respective conservative ratios above the target levels. Target level of conservatism here implies the one which is estimated by means of the regression model. After a regression model is estimated following the equation sets (1) and (2), it also yields predicted values of the dependent variable. The differences between the actual and predicted values are the origins of the dummy variables created for Model (B) in all three cases. Since the predicted values are completely explained by the explanatory variables being included in the model, any deviation from them might be regarded as an abnormality. This abnormality is taken as a hint about whether the firm is actually following conservative policies or not. The predicted values of the dependent values show the ideal figures of the variables that the firms must align themselves to in which case they are regarded as neutral, i.e., neither conservative and nor liberal. In case that the deviation is negative, it implies a liberal attitude towards company policies, while a positive deviation indicates a conservative mindset. To explain it in simple words, the predicted values are the ideal ways in which the given firms must behave given their respective financial states that are explained through the regressors. Any deviation from such ideal behavior might be assumed as adopting excessively stringent policies or excessively liberal policies, which frame the picture for conservatism. After these dummy variables are assigned, the next step will be to include them into logit regressions which aim to find whether financial conservatism is actually dependent upon the financial policies being adopted by the firms. The logit equations to be estimated are of the following forms – Cash conservatism = f (CFLOW, LIQ, LEV, MTOOK, INVRAT, LOGSAL, PROFIT, TANGIBLE, DIVIDEND, Time, Sector) …. (3) Leverage conservatism= g (CFLOW, LIQ, CASH, MTOOK, INVRAT, LOGSAL, PROFIT, TANGIBLE, DIVIDEND, Time, sector) … (4) Financial conservatism = h (CFLOW, LIQ, LEV, MTOOK, INVRAT, LOGSAL, PROFIT, TANGIBLE, DIVIDEND, Time, Sector) … (5) The above equations will include dummies for Time and Sectors as well, in order to check for the use of pooled data. The explanatory variables being included in the above three equations have been chosen according to their respective powers to represent the financial state that the particular company is in. McFadden’s R Square value will also be checked as a measure of goodness of fit. The goodness of fit measures will be held relevant after examining the associated values of estimated F-statistics. After assessing the R Square values, the next step will be to examine the levels of statistical significance of each individual explanatory variable. The individual levels of significance would be tested with the help of Student’s t-statistics and the statistical significance of these estimated parameters will be assessed with the help of p-values. 4.1 Data Collection Methods The data to be employed in the present context have been gathered for 943 firms based in USA between 1998 and 2006. The data being collected in the present context is annual in nature and have been gathered from the respective company annual reports. The information being collected is on various financial ratios which will be treated as variables and inputted in the aforementioned models. Chapter 5 – Interpretation of Data The data being collected above have been employed in the manner depicted in the methodology of the paper. The next step will be to figure out whether cash balance and leverage ratios of firms could actually be assessed with the help of a handful of financial ratios as stated in equations (1) and (2) in the Methodology. In order to evaluate these facts, the appropriate step will be to observe the Adjusted R-Square values and to assess their respective statistical significance levels as well. The Adjusted R Square values along with their estimated F-statistics and corresponding p-values for each pair of equations for each year have been presented in the table below. Table 2 Year Adjusted R Square for Cash Balance P-value of estimated F statistic Adjusted R Square for Financial Leverage P-value of estimated F statistic 1998 0.328075 0.00000 0.180674 0.00000 1999 0.327510 0.00000 0.231186 0.00000 2000 0.345598 0.00000 0.483168 0.00000 2001 0.331976 0.00000 0.141186 0.00000 2002 0.416046 0.00000 0.189662 0.00000 2003 0.457129 0.00000 0.139733 0.00000 2004 0.482594 0.00000 0.149477 0.00000 2005 0.457103 0.00000 0.154588 0.00000 2006 0.412482 0.00000 0.167723 0.00000 Thus, the OLS regression results show that Adjusted R Square values for equations attempting to estimate Cash Balance are far higher than those for the equations attempting to explain deviations in financial leverage. However, the models being estimated for each of the nine years are found to be statistically significant implying that the explanatory variables being chosen are rather sensible and throw a relevant impact. The next step will be to assess the degree to which the financial ratios are capable of illustrating the adoption of conservative policies by any particular firm. Cash conservatism will be followed by leverage conservatism and finally financial conservatism Cash Conservatism In order to assess the degree of conservatism being followed, three models have been used up as specified in the Methodology section. A brief summary about the models being estimated have been produced in the following tabulated form. The figures corresponding to the names of the explanatory variables are the respective estimated coefficients, while the expressions in parentheses are the respective p-values, which could be used up in answering whether each one of them can significantly influence the dependent variable or not. Table 3: Explanatory powers of regressors in influencing cash conservatism policy Explanatory Variables Model A Model B Constant -0.677028 (0.2019) -0.373933 (0.1389) CFLOW 1.054691 (0.2786) 0.34414 (0.2718) LIQ 6.048071 (0.0000) 0.076705 (0.6225) LEV -3.080858 (0.0000) -0.088576 (0.5068) MTOOK 0.060593 (0.0000) 0.012156 (0.2589) INVRAT 7.880317 (0.0000) -0.814735 (0.1494) LOGSAL -0.320610 (0.0000) -0.005564 (0.7205) PROFIT 0.762181 (0.0000) -0.421134 (0.2055) TANGIBLE -3.754861 (0.0000) 0.235010 (0.0823) DIVIDEND 1.675938 (0.0428) -0.405941 (0.5540) Time 0.143543 (0.0000) -0.007542 (0.4031) Sector 0.327068 (0.0000) 0.006038 (0.5595) The p-value statistics depict that most of the explanatory variables being used in models A are capable of significantly influencing the dependent variable, cash conservatism. However, in case of model B, none of the regressors are found to be capable of exerting significant influence over the dependent variable. The following table depicts the estimated values of McFadden’s R-Square and the corresponding LR statistic meant at assessing the significance of these goodness-of-fit figures. Table 5: McFadden’s R Square values for models aimed to estimate cash conservatism Model A Model B 0.417587 (0.000000) 0.000889 (0.566893) The above figures suggest Model A to be the better one out of the two. Thus, on the basis of the above results, the following summary could be drawn about the degree to which the included explanatory variables are capable of addressing the cash conservativeness of the firms. The regressors exerting a significant influence over the dependent variable are found to be ‘Liquidity’, ‘Extent of Leverage’, ‘market-to-book-value ratios’, ‘Investment Ratio’, ‘logarithmic transformation of sales’, ‘Profit’, ‘Proportion of Tangible Assets’, ‘Dividends’, ’‘Time’ and ‘Sector’. The influence of ‘LEV’, ‘LOGSAL’ and ‘TANGIBLE’ are found to be negative as against the remaining other significant variables. In other words, higher the leverage of a firm is, lower will be its degree of cash conservatism, higher the growth in sales of a firm is, lower will be the degree of cash conservatism and lastly, higher the proportion of tangible assets, lower will be the degree of cash conservatism. Higher leverage implies higher degree of dependence upon debts over equity financing, which is normally the case for non-conservative firms. When firms experience a rise in sales figures, they are instigated towards adopting risk and often enable steps meant to raise their sales further; in order to adopt such steps the firm cannot retain back much amount of money with it but rather has to be highly volatile in nature. Lastly, higher the proportion of tangible assets, the firms need not retain their cash as these assets could serve as the firm’s resources at periods of dire stringency. Liquidity is found to positively influence cash conservatism which however, deviates from theoretical lines. However, the positive influence exerted by ‘INVRAT’ and ‘PROFIT’ are quite sensible given that in either case, the firm needs to retain money for investments. Time and sector also exert a positive influence, implying that as time moves forward, the firms get more and more cash conservative. However, the positive influence wielded by sectors is confusing. Leverage Conservatism The results of the three models being estimated to check for the presence of leverage conservatism has been presented in the table as follows. However, as logit model estimates the log-odd ratio of influence of the particular regressor upon the dependent variable. Thus, the next table converts these values to their actual forms which imply the marginal impact of the corresponding independent variable upon the regressand. Table 6: Explanatory powers of regressors in influencing leverage conservatism policy Explanatory Variables Model A Model B Constant -0.290413 (0.4620) -0.006407 (0.9785) CFLOW 2.062654 (0.0024) -0.073291 (0.7861) LIQ 2.858998 (0.0000) -0.062567 (0.6968) CASH 4.456843 (0.0000) -0.038670 (0.8706) MTOOK 0.074570 (0.0000) 0.009680 (0.0404) INVRAT 6.140450 (0.0000) 0.045488 (0.9339) LOGSAL -0.247730 (0.0000) -0.006167 (0.6868) PROFIT 1.357931 (0.0247) 0.444616 (0.1487) TANGIBLE -1.437049 (0.0000) -0.095919 (0.4714) DIVIDEND -0.022873 (0.9771) -1.167790 (0.1359) Time 0.039384 (0.0057) -0.013015 (0.1437) Sector 0.071343 (0.0000) -0.000442 (0.9664) McFadden’s R-Square values corresponding to the above models have been cited in the table below. Table 8: McFadden’s R Square values for models aimed to estimate leverage conservatism Model A Model B 0.254152 (0.000000) 0.0010007 (0.430689) The table suggests Model A to be the better one, in terms of McFadden’s R-Square. Thus, the explanatory powers of the regressors could be assessed on the basis of the outcome of Model A. It shows that, Dividend is the only variable having an insignificant explanatory power. Moreover, leverage ratios have been omitted while estimating the model as it is found to be completely explaining deviations in the binary dependent variable. Growth in sales volume (LOGSAL) and proportion of tangible assets (TANGIBLE) are the only two variables exerting a negative influence and the explanations corresponding to them are similar to that for the cash conservative model. The remaining variables are found to depict similar signs as those for the model estimating ash conservatism and thus, their illustrations would be the same. Financial Conservatism Financial conservatism had been run on the basis of the criterion specified in the methodology above. The estimated result has been summarized as follows – Table 9: Explanatory powers of regressors in influencing financial conservatism policy Explanatory Variables Model A Model B Constant -1.158235 (0.0288) -1.174927 (0.0001) CFLOW 1.36369 (0.1530) 0.097882 (0.8418) LIQ 6.652196 (0.0000) -0.131877 (0.4680) MTOOK 0.069024 (0.0000) 0.026193 (0.0413) INVRAT 8.822260 (0.0000) -0.417521 (0.5480) LOGSAL -0.369030 (0.0000) -0.015967 (0.4044) PROFIT 1.083012 (0.2201) 0.638634 (0.1677) TANGIBLE -3.595637 (0.0000) 0.149355 (0.3708) DIVIDEND 1.470152 (0.0803) -2.218588 (0.0799) Time 0.155939 (0.0000) -0.012310 (0.2656) Sector 0.354810 (0.0000) -0.011211 (0.3850) The values of McFadden’s R-Square for the respective models have been presented in the following table for comparative purposes. Table 8: McFadden’s R Square values for models aimed to estimate leverage conservatism Model A Model B 0.398026 (0.000000) 0.002773 (0.014630) The goodness of fit measures show Model A to be a far better estimator of financial conservativeness than its two peers. Hence, this is the one that has to be zeroed upon and used accordingly to assess the influence of the explanatory variables. CFLOW, PROFIT and DIVIDEND are the three variables which are incapable of throwing significant influence over the dependent variables. Of the variables which throw a significant influence, leverage ratios (LEV), growth in sales (LOGSAL) and proportion of tangible assets (TANGIBLE) are found to be exerting a negative impact. The rationales behind the negative influence of all these variables have already been elaborated before. The variables which throw a positive influence are LIQ, MTOOK, INVRAT and DIVIDEND. Higher that MTOOK is, it means that the company deals in rather risky business which is why it needs to adopt conservative policies. Similarly, high DIVIDEND and INVRAT imply higher amounts of investment which is why the company needs to retain money with itself and thus adopt conservative financial policies. However, the rationale behind the sign of LIQ is still vague, given that it doesn’t go in line with theory. Chapter 6 – Conclusion The paper suggests that financial conservatism cannot be completely explained by means of financial ratios which implores that degree of financial distress could actually help in deciding whether a company adopts financially conservative policies or not. The financial situation of a company is likely to be reflected through its financial ratios which are again held responsible for deciding financially conservative policies. While for some financial ratios higher values mean higher financial status, they are corresponded by conservative policies. 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Appendix Cash Conservatism (A) (B) Leverage Conservatism (A) (B) Financial Leverage (A) (B) Read More