The Impact of Financial Distress on Firm Performance: Evidence from Listed Companies in Sri Lanka

Abstract

Introduction: Financial distress indicates the firm's risk of bankruptcy or financial instability. This study aims to identify the effect of financial distress on firms' performances during the economic crisis (2019–2023) and before the crisis (2015–2023) and analyze consumer services, capital goods, and food, beverage & tobacco sectors, which have the highest market capitalization.

Methodology: This study collected data from 113 firms listed on the Colombo Stock Exchange under three sectors for a sample period of nine years, from 2015 to 2023. Using a quantitative approach, this study collected secondary data from the annual reports of the selected companies. The Altman Z-score was used as the explanatory variable to reflect the financial distress of the companies selected. Return on assets was used to measure the firm performance of the selected companies. Further, firm size and inflation rate were used as the control variables, and corporate governance was used as a moderate variable. Panel regression models were used in this study to analyze the data in STATA and SPSS software to test some hypotheses.

Findings: The results of the study revealed that there were significant differences in financial distress before and during the crisis, with the compounded effects of financial distress and crisis periods further declining the firm's performance. Also, there are significant differences in financial distress levels between the three sectors, and corporate governance acts as a critical moderating factor, and its effectiveness varies across sectors.

Conclusion: The findings of the study have practical implications for the strategic leaders of the three sectors. The study underscores the importance of early distress detection and adaptive governance practices to enhance firm performance, especially improving firm performance during economic crises.