Indirect Costs of Financial Distress and Bankruptcy Law: Evidence from Trade Credit and Sales*

Abstract

We argue that stronger debt enforcement in bankruptcy can reduce indirect costs of financial distress: (i) by increasing the likelihood of restructuring outside bankruptcy and (ii) by improving the recovery rate of stakeholders, such as trade creditors, through explicit legal provisions. Consistent with these predictions, we find that when debt enforcement is stronger, financially distressed firms are less exposed to indirect distress costs in the form of reduced access to trade credit and forgone sales. We document these effects in a panel of firms from 40 countries with heterogeneous debt enforcement characteristics and in differences-in-differences tests exploiting several recent bankruptcy reforms.

أثر التعثر المالی وحجم الشرکة وجودة المراجعة علی إدارة الأرباح -دراسة تطبیقیة علی الشرکات المقیدة بالبورصة المصریة(باللغة الانجلیزیة)

“…The financing activities of the business are the main backbone for the survival of organization. The business is called bankrupt when its total liabilities are higher than its fair value of its assets in the market (Sautner and Vladimirov, 2018). Parkinson (2018), defines the financial distress as the probability of bankruptcy that depends on the magnitude of current assets and level of credit worthiness.…”

“…Then the literature moved to defining financial distress and how it can affect firms' performance. Most prior studies agreed that there is no one single definition for financial distress but simply it can refer to the probability that the firm can have difficulties in paying its debts and cash flow requirements which raises their likelihood of getting bankrupt (Sautner and Vladimirov, 2018), Parkinson (2018), Kamaluddin et al, 2019, Hu andAnsell 2005;Fallahpour et al, 2017). This could be mainly attributed to poor management performance as indicated by Idrees and Qayyum, (2018) and Lee et al, (2017) or due to factors that exceed management control like pandemic, worldwide recession and political troubles Karugu et al, 2018).…”

Financial Characteristics of Distressed Firms: An Application of the Altman Algorithm Model

“…One of the most significant issues confronting firms in financial distress is the inability of managers to persuade external stakeholders such as creditors and suppliers to continue doing business with the distressed entity (Sautner & Vladimirov, ). The norm is that as distress progresses to the possibility of bankruptcy, many stakeholders start jumping ship which can speed up the rate of deterioration of the financial position of the firm.…”

“…Sautner and Vladimirov () explained that indirect cost arises from deflated access to trade credit and foregone revenue from customers. According to Opler and Titman (1993), stock prices decline significantly when firms enter into a state of distress as revenue from direct sales diminishes.…”

Impact of Bankruptcy Eligibility Requirements and Statutory Liens on Borrowing Costs

“…Within the corporate literature, Qian and Strahan () found strong creditor protection laws resulted in concentrated ownership, longer maturities, and lower interest rates for borrowing firms. In a similar Sautner and Vladimirov () report that stock returns accumulate at lower (higher) rates in countries with strong (weak) creditor rights. Following their examination of bankruptcy laws in 49 countries, López de Silanes, Rafael La Porta, and Robert () came to a conclusion that the extent of investor protection in bankruptcy process is significantly integrated in financial outcomes.…”