How do financial constraint and distress measures compare?

Abstract

This paper compares three popular financial constraint measures (the Kaplan and Zingales, 1997 (KZ); Whited and Wu, 2006 (WW); and Hadlock and Pierce, 2010 (SA) indices) with three of the most widely used distress measures. Although prior studies highlight the necessity for distinguishing between financial constraint and financial distress, researchers have used these measures without examining how they correlate with each other. This paper finds a strong positive correlation between KZ and the distress measures. Constrained firms, as measured by KZ, also exhibit characteristics very similar to those of distressed firms. On the other hand, the WW and SA correlations with the KZ and distress measures are substantially weaker. In order to distinguish financial constraint from distress, it is hypothesized that distressed firms reduce debt rather than invest when additional cash becomes available, a pattern typically expected from distressed firms but not constrained ones. Consistent with this hypothesis, it is found that both KZ constrained firms and financially distressed firms exhibit higher debt reduction-cash flow sensitivities but lower investment-cash flow sensitivities. These patterns are not found when analyzing data using the WW and SA measures. Based on these findings, it is concluded that the KZ index is more related to financial distress than financial constraint. © Joonghyuk Kim, James L. Park, 2015.