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Financially constrained firms are more susceptible to a stock price crash – but why?

This article is written by Guanming He, Professor of Accounting at Durham University Business School, and is based upon his research paper ‘Financial Constraints and Future Stock Price Crash Risk’, co-authored by a PhD student, Helen Ren.

 There are a wide range of factors that can cause a public company’s stock price to crash. These can be uncontrollable, external factors such as government sanctions, which we have recently seen employed by Donald Trump on Russian oligarchs (causing Russia’s main share index to crash by 11%),or internal factors, for example, Facebook’s stock price crashing by 16% as a result of a recent data breaching scandal.

These recent examples are proof that even the world’s largest, most stable and well-known companies can be suspect to a stock price crash. The possibility of such crashes occurring naturally causes uneasiness across all firms, regardless of their standing or success.

Although these stock price crashes can have huge ramifications for a firm, it is arguably the company’s investors that stand to be the parties most affected. As a firm’s stock value drops dramatically, shareholders can see their investments also plummet in worth. This likely causes incumbent investors to consider pulling their investments and deters other potential investors. It is no wonder then that those at the head of public companies look to do everything possible to prevent such situations from occurring.

However, even firms that experience the opposite of a stock price crash – a prolonged period of excessive stock price rises – can also be incredibly susceptible to a stock price crash in the long term, in which the stock’s metaphorical bubble ‘bursts’. Therefore, it is important for firms to find balance between increasing their stock prices and preventing a crash because of these rises. This is a tricky balance to achieve, and some firms find it a lot harder than others.

In my recent study, conducted alongside my PhD student, Helen Ren, we researched the impact that financial constraints have on the potential risk of a firm’s stock price crashing. For this, we defined firms experiencing financial constraints as those who were facing difficulty in funding their desired investments and used a large sample of U.S. listed firms across a 20-year period from 1995-2016.

Our research revealed that financially constrained firms were indeed much more likely to be at risk of a stock price crash. But why is this? My research explored a number of contributing factors.

Higher Default Risk

Firms experiencing financial constraints are highly unlikely to have any extra available cash to fund their desired investments. This is likely to lead to firms exploring new means of raising money to fund these investments such as short-term financial assistance, most likely in the form of loans.

Although these loans may be helpful in the short-term, such financially constrained firms may then find themselves hard-pressed to continue to meet the legal covenants to repay loans or resulting debts due in the long-term. This induces a higher default risk for a firm, meaning that the likelihood of them paying back all their debt regularly and on time is slim.As a result, corporate failure becomes a much higher possibility – which destines a firm for a stock price crash.

Bad News Hoarding

Bad news for a firm easily has the potential to damage reputation, drastically increase the costs of issuing equity and debt, and could be a significant contributing factor to a stock price crash. Financially constrained firms are significantly more likely to be affected by such bad news compared to firms who have spare funds to deal with the consequences of a knock to reputation.

Therefore, it is no wonder that managers at the helm of financially constrained firms look to hoard and bury bad news in the hope of avoiding its negative impact, at least until they’ve secured vital external funds. However, the choice to withhold bad news from shareholders, customers, suppliers and employees is not a wise one from a long-term perspective.

With a firm’s external environment changing unforeseeably and uncontrollably, and the limited control a firm has over their own internal environment, the ability for a firm to not only anticipate but also consistently withhold bad news only stretches so far.At some point, the amount of withheld bad news will reach a threshold. Once this threshold is crossed, bad news will become completely uncontainable and when revealed all at once, can result in causing a sudden, dramatic price drop – known as a stock price crash.

Coincidentally, as bad news is hoarded a firm is likely to experience a prolonged period of rising and inflating of its stock price. As the stock price becomes increasingly overvalued, the risk of a crash increases also.

Though financially constrained firms are much more susceptible to a stock price crash, there are some tactics that managers can use, other than gaining extra external funds, to help alleviate this risk, and resulting corporate failure. These include:

Minimising Tax

One way for a firm to gain extra funds without having to source out new investors can be by looking at ways to minimise their tax payments legally and ethically, of course. The extra funds made available by minimising tax payments will alleviate the firm’s financial constraints, lower its default risk and create more money for potential investments. However, in some instances the attempt to minimise corporate taxes could be regarded as unethical and as a result generate some bad news for the organisation, therefore this tactic should be treated with caution.

Building Up Strong Corporate Governance

Weak corporate governance can easily lead to various management issues, such as a divided workforce more concerned with personal job prospects and reputation than company reputation, or managers being offered compensation to act unethically for short-term gains. Such management issues increase the potential for bad news, which as highlighted earlier will inevitably cause damage to a financially constrained firm’s long-term stock performance.

Strong and united corporate governance can be built by introducing thorough monitoring of management practices and by increasing managers’ accountability to their employees, customers, suppliers and investors. One way to strengthen corporate governance is by granting the firm’s external directors with more stocks or stock options to incentivise them to better monitor firm management. A strong corporate governance will reduce bad news hoarding and thereby lower the risk of a future stock price crash.

Increasing Credit Rating

Having a low credit rating makes it difficult for a firm to gain access to external funds such as loans for investments and induces a shorter distance to default for the firm. It is therefore important that a firm looks at ways to increase its credit rating, such as increasing information transparency by disclosing more value-relevant corporate information to the public. This will make it a lot easier for a firm to obtain external funds through loans, thus making the firm less prone to a default and a stock price crash.

Firms confronted with financial constraints may use the above tactics to alleviate the potential of a stock price crash, attract more external funds, thereby sustaining and expanding their business for long-term benefits.

Guanming He

Guanming He is an associate professor in accounting at the Durham University Business School. His research areas focus on financial reporting and disclosures, insider trading, financial analysts, and risk management, and has had his research published in various prestigious international journals such as The Financial Review, The Review of Accounting Studies, and The International Journal of Accounting.