International Finance
Magazine May - June 2018 Opinion

Are firms operating under financial constraints more susceptible to stock price crashes?

Guanming He, Professor of Accounting at Durham University Business School, based upon his research paper Financial Constraints and Future Stock Price Crash Risk, along with PHD student, Helen Ren tells us what could be the possible reasons for a company’s stock price to crash

Stock market crashes are not uncommon in the marketplace and the risk of a crash occurring is, understandably, likely to cause uneasiness within a firm as this can have huge ramifications not only for the organisation, but also the economy as a whole – just look at the 2008 global financial crisis for a perfect example.

There are a huge range of factors that can cause a firm’s stock price to crash. Whether it be external factors such as changes in government regulation and a prolonged period of excessive stock rises, or internal factors such as changes in management, financial announcements or a knock to reputation.

Even in recent weeks we have seen one of the world’s largest and most well-known firms, Facebook, experience a stock price crash, dropping abruptly by 16% in the immediate aftermath of a recent data breaching scandal, which reportedly involved Facebook’s harvested user data being used for political gains by consultancy firm, Cambridge Analytica. This story serves as a stark reminder that no public company is exempt from this risk – even the world’s biggest firms.

Not only do stock price crashes damage the firm, they hit the investors too. As a firm’s stock value drops shareholders can see their investments decrease dramatically in worth. In the long-term this can cause irreparable damage if shareholders then decide to pull their investment, or if a firm fails to secure further investment in future, so it is no wonder that those at the head of public companies look to do everything possible to prevent such situations from occurring.

Attempting to increase a firm’s stock price whilst simultaneously preventing a crash can prove to be a tricky balance to achieve. However, there are some firms which may find this much harder than others.

In my recent study, conducted with my PHD student, Helen Ren, we researched the impact that financial constraints can have on the possibility of a firm’s stock price crashing, using a large sample of U.S. listed firms for the period of 1995-2016. Defining firms experiencing financial constraints as those who were facing difficulty in funding their desired investments, we found that such firms were more likely to be at risk of a stock price crash than others. But why is this? My research explored a number of factors that can contribute to a potential crash. Two such common occurrences are;

Bad News Hoarding
Firms that experience financial constraints are a lot more likely to feel the effects of bad news than those firms which have available funds and are vastly more financially secure, as bad news and its potential to damage a firm’s reputation can drastically increase the costs of issuing equity and debt. Managers at the helms of financially constrained firms have valid reason to want to hide bad news, at least until they have secured the vital external funds needed for company development.

However, withholding bad news from customers, employers and other stakeholders is not always the smart choice to make. With a firm’s environment changing constantly and unforeseeably, managers will find it difficult to not only anticipate but also control bad news, and at some point the ability of a firm to withhold this information will hit a threshold. All the hoarded bad news will become uncontainable and, like the straw that breaks the camel’s back, will be released at once, resulting in a sudden, dramatic price drop – a stock price crash.

Not only will bad news hoarding cause a stock price crash directly but, as the withheld bad news accumulates, stock prices will become increasingly overvalued, leading to a higher risk of future stock price crashes which could be even more damaging for the firm.

In essence, with strong incentives to secure external finance, firms experiencing financial constraints are more likely to withhold bad news, and thus have a much higher risk of a future crash compared to unconstrained firms who can deal with impacts of bad news.

High Default Risk
Firms that experience financial constraints and lack extra available cashflow are a lot more likely to experience difficulty in financing their investment needs and, as a result, far more likely to take out loans and other means of short-term financial assistance. However, this lack of funds can also leave some companies with such little money that they are unable to regularly reach the legal obligations to repay any debt payments and loans they may have used, creating a higher default risk. A crash resulting from corporate failure is more likely to occur to a firm with high default risk, thus financially constrained firms are considerably more prone to stock price crashes.

Although financially constrained firms are much more likely to experience a stock price crash, there are some tactics that managers and owners can utilise in order to decrease the risk of a crash occurring and help ensure their firm’s growth and survival.

Strong Corporate Governance
Bad news is much more likely to arise when conflict exists between shareholders and the firm’s management. This bad news might be attributed to various factors; management issues, concerns about job prospects, personal reputation, or even managers being offered compensations to withhold bad news or act unethically for short-term gains. Ensuring a strong and united corporate governance not only puts management under intense monitoring but increases their accountability to staff, customers and investors. This reduces the likelihood of hoarding bad news, and as a result, reducing the risk of a future crash.

This strong corporate governance can be achieved in many different ways, one of which for example, could be granting the firm’s outside directors with more stocks or stock options to incentivise them to better monitor firm management.

Increasing Credit Ratings
Not only does a low credit rating imply a shorter distance to default, but it also means that a firm can find it difficult and costly to access external funds for investment. Therefore it is important for managers heading financially constrained firms to look at alternative ways to boost credit ratings, such as increasing information transparency by disclosing more value-relevant corporate information to the public, so that their companies are less prone to default and the likelihood of experiencing a stock price crash.

Minimising Tax
Although in some cases a firm attempting to pay the minimum amount of tax that is legally possible may provoke some bad news for an organisation, it is likely to generate a lot more internal cash flow. By looking at alternative methods of tax payments, reducing the firm’s tax legally will reduce pressure, alleviating the financial constraints and default risk and creating more money for the firm’s investments. However this may not always be adjudged to be ethical by all, and should therefore be approached with transparency and caution.

It is important that firms who are financially constrained investigate ways in which they can alleviate these constrains so that they are in less risk of a crash, and inevitable corporate failure.

About 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 and financial analysts, and has had his research published in prestigious journals such as The Financial Review, The Review of Accounting Studies and The International Journal of Accounting.

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