The Effect of Financial Distress on Stock Returns of Firms Quoted at the Nairobi Securities Exchange

Abstract

The literature shows that publicly traded firms do encounter financial distressed from time to time but does not conclusively determine whether or not such situations affects the returns of equity stocks issued by the firms. The overall objective of the study was to estimate financial distress in the firms quoted in the Nairobi Securities exchange. The study proceeded to test the effect of financial distress on stock returns. Applying descriptive correlation design, the study involved a total of 26 firms selected from the population of 61 quoted firms. It excluded the firms in the banking, insurance and manufacturing sectors to which the chosen model was not applicable. The study applied secondary data from audited financial reports for nine years to estimate financial distress using the Altman's Z" -score model. The score representing the probability of a company falling into financial distress was computed out of four financial ratios namely: Working capital/Total assets; Retained earnings/Total assets; Earnings before interest and tax/Total assets and Book value of equity/total liabilities. The scores were then weighed against Altman's zones of classification namely: 'safe zone, 'grey zone' and 'distress zone. The study found that financial distress was prevalent among the sampled firms but the estimates obtained from the sample were not significant enough to be generalized on the population. Stock returns were then calculated for quarterly periods out of daily price data published by Nairobi Securities Exchange and dividend payouts. Computed stock return values were correlated with the financial distress scores. The resulting correlation coefficient indicated a weak positive correlation between financial distress and stock returns. Coefficient of determination indicated that financial distress did not explain any variation in the firm's stock returns. The results suggest that the firms quoted in Nairobi Securities Exchange did experience financial distress from time to time to which there was minimal reaction from market observable in terms of movement of stock returns. Recommended policy interventions include public education on equity stock trading and review of financial reporting standards for publicly quoted firms. Further research applying alternative test parameters and models for financial distress and incorporating other firms quoted in the Nairobi Securities exchange that were not sampled for this study is recommended.