Earnings Downside Risk and Capital Structure

Abstract

Financial statements are known to reveal firms fundamental risks. Especially when firms are undergoing downward times, firm performance stays below its reasonable expectation. EDR (Earnings Downside Risk) measure is known to capture a firms earnings down side risk using residual from the ROA expectation model. EDR links to bad performance, and subsequent performance should be negatively associated with EDR. And the firms fundamental risk affects capital structure. I find evidence that firms with high EDR tend to have loss and lower profit. As EDR is higher, firms generate equity financing more than debt financing. Specifically, EDR is positively associated with equity financing, however, the association is insignificant with debt financing. Also theres positive relation between EDR and net sales in divestiture. In a result of financing, level of internal cash is significantly higher in the high EDR firm than in the lower EDR firm. High EDR indicates that firm cannot earn extra profit (alpha or residual income) with current operating system. In other word, the firms that have high EDR need to be more profitable through focusing on the growth potential enterprise. In the trial for the choice and concentration, firms need financing. Financing is very important for firms survival especially in the downside risk. This study has incremental contribution to examine firms behavior when they have uncertainty, especially when facing downside risk. The findings allow to have better understanding of firm behavior.