Using Financial Ratios and Managing Financial Risks in Investing in “Grey” Zone Companies: Evidence from Malaysia

Abstract

Most studies on company financial performance have mainly focused on either the successful companies or companies that are already in financial distress. However, there is a large group of companies that are in between, that is they are average performers and can be described as belonging to the “grey” zone. The purpose of this study is to analyze the companies in the “grey” zone to identify those that are likely to go into financial distress over time and those that may progress into the good financial performing category. Utilizing 3 key financial ratios, 90 Malaysian publicly listed companies in the manufacturing sector were initially classified into 3 clusters using“ Cluster Analysis” over the period 2006-2010. The classification accuracy in each year is then tested by applying Multiple Discriminant Analysis (MDA). Interestingly, a classification accuracy of more than 90% was obtained for each of the 5 years. The companies in the “grey” zone in the years 2006 and 2010 were further cluster analysed into the below average and into the above average clusters. Out of the 63 companies that were found to be in the “grey” zone in the 2 years under review, 31 companies or 50% improved their position, 18 companies or 28% declined with 14 companies or 22% remaining stagnant. Of special interest would be 5 companies that moved up 3 clusters from poor to good performers and 21 companies that moved up 2 clusters from poor to above average performers. Of concern would be 17 companies that move down one cluster and 1 company dramatically collapsing two clusters downward. A key finding of the study is that by appropriately utilizing financial ratios, investor risk can be minimized. In addition it enhances credit evaluation, stock market value and investment potential.