ANALYSIS OF FINANCIAL DISTRESS AND ITS

DETERMINANTS: (A CASE STUDY OF SELECTED

PRIVATE COMMERCIAL BANKS IN ETHIOPIA)

A RESEARCH PROPOSAL SUBMITTED TO THE DEPARTMENT OF

ACCOUNTING AND FINANCE IN PARTIAL FULFILLMENT OF
THE REQUIREMENT FOR THE MASTER OF DEGREE OF
ACCOUNTING AND FINANCE

PREPARED BY: DAWIT TESFAYE

ADVISOR: ABDI DUFERA (PHD)

HARAMBEE UNIVERSITY
SCHOOL OF GRADUATE STUDY
DEPARTMENT OF ACCOUNTING AND FINANCE

January 2023
Adama, Ethiopia
DECLARATION
I declare that the proposal entitled “Analysis of financial distress and its determinants
of selected private commercial Banks in Ethiopia” submitted to Accounting and Finance
Department of Harambee University, in partial fulfillment of the requirements for the
award of Degree of Master of Science in Accounting and Finance is my original work
and have not been previously presented or submitted at this or any other university and that
all references materials used in this thesis have been dully acknowledged.

Name: ___________________________

Signature:_________________________

Date: January, 2023_________

CERTIFICATION
This is to certify that Ato Dawit Tesfaye has carried out his research work on the title of
“Analysis of financial distress condition and its determinants of selected private commercial
Banks in Ethiopia’’ under my supervision. This work is complying with the regulations of
the University and meets the accepted standards with respect to originality and quality.

Advisor

Name: Abdi Dufera (PhD)

Signature: _________________

Date: ____________________

Harambee University

School of Graduate Study

Department of Accounting and Finance

ACKNOWLEDGEMENT
My deepest and warmest thank goes to the Almighty GOD and his mother Sanity Marry,
who help me in all aspects of my life and for all the strength they gave me to make it this
far. And I would like to thank my advisor Dr. Abdi Dufera for his professional and
constructive comments, and also for his understanding and encouragements.
Table of Contents
DECLARATION..................................................................................................................................ii
CERTIFICATION................................................................................................................................iii
ACKNOWLEDGEMENT....................................................................................................................iv
Abstract..............................................................................................................................................viii
CHAPTER ONE....................................................................................................................................1
1. INTRODUCTION.........................................................................................................................…1

1.1. Background of the Study..................................................................................................................1

1.2 Statement of the Problem..................................................................................................................1

1.3. Objectives of the Study....................................................................................................................2

1.3.1. General objective...................................................................................................………..2
1.3.1. Specific objectives...............................................................................................................3

1.4 Literature-driven Hypotheses............................................................................................................3

1.5 Significance of the Study................................................................................................................5

1.6. Scope of the Study...........................................................................................................................6

1.7 Limitation of the Study
1.8 Organization of the Study
CHAPTER TWO 7
REVIEW OF RELATED LITERATURE.............................................................................................7

2.1Review of Theoretical Literature.......................................................................................................7

2.1.1History of Banking Industry in Ethiopia................................................................................7
2.1.2 Financial Distress..................................................................................................................8
2.1.3 Financial Distress Prediction................................................................................................9
2.1.4 Determinants of Financial Distress.....................................................................................12

2.2 Empirical Literature Review...........................................................................................................13

2.2.1 Empirical literature on financial distress in Global context.................................................13
2.2.2 Empirical literature on financial distress in African context...............................................14
2.2.3 Empirical literature on financial distress in Ethiopian context............................................15

2.3 SUMMARY OF LITERATURE REVIEW AND RESEARCH GAP............................................15

2.4 CONCEPTUAL FRAME WORK..................................................................................................16

CHAPTER THREE.............................................................................................................................17
3. RESEARCH METHODOLOGY.....................................................................................................17

3.1 Research Design.............................................................................................................................17

3.2 Data type and Source......................................................................................................................18

3.3 Sampling Procedure........................................................................................................................18

3.3.1 Target population................................................................................................................18
3.3.2 Sample Technique...............................................................................................................18

3.4. Methods of Data collection............................................................................................................19

3.5 Data Analysis Techniques...............................................................................................................19

3.6 Model Specification........................................................................................................................19

3.7 Econometric Model.........................................................................................................................20

3.8 Variable Descriptions......................................................................................................................21

3.8.1 Dependent variables............................................................................................................21
3.8.2 Independent Variables........................................................................................................21

Budget breakdown................................................................................................................................22

Table below will show estimated cost to complete the research study..................................................22
ABSTRACT
The main aim of this study will be to investigate the financial distress condition and its determinant
of selected private commercial banks in Ethiopia. Thirteen private commercial banks that had at
least ten years of life will be selected by using the purposive sampling method. Document review will
be used for collecting data from the 2011- 2020 annual reports. In line with this objective, the study
will adopt quantitative method of research approaches to test the study hypothesis. The study will
apply Altman's 2000 Z”-score model as the proxy for financial distress and panel data regression
analysis with its random effect estimate to test a series of hypotheses that emerge through the review
of existing literature. A test of normality, multicollinearity, heteroscedasticity, and autocorrelation
will be conducted on the data to reach confident conclusions.
Key Words: Financial distress condition, R2, Random effect regression method, private commercial
Banks in Ethiopia, Z” score
 CHAPTER ONE
1. INTRODUCTION
1.1. Background of the Study
The financial sector plays a crucial role in economic growth and industrialization through
channeling funds from the surplus unit or depositors to the deficits unit or the borrower, in
the process gaining from the spread of the different interest charged. Their intermediation
role can be said to be a catalyst for economic growth (Funso, Kolade, and Ojo, 2012).The
role and importance of banks in the modern economy are enormous and the product and
services they provide growing in terms of depth, the number of the institution, and the
amount of money managed by such institutions, the roles of such banks are paramount in
developing countries like Ethiopia where the financial market is underdeveloped and none
existed.
According to Ephrem and Nidu (2015), the financial health status of selected private
commercial banks of Ethiopia has been healthy for the entire study period. However, the
financial health of the banks was in a gray area in the early 2000s. At the beginning of the
2000s almost, all banks were not that healthy since they were in the gray area which is an
intermediate zone between bankruptcy and a healthy zone. The zone of gray area is an
undesirable area of financial health that is characterized by financial distress than healthiness.
Thus, the researcher seeks to identify the determinants of distress of Ethiopian private
commercial banks; to do so, the research will measure their level of financial distress, using
the revised Altman Z-score (Z’ score) and analysis will be drowning the level of financial
distress with the identified determinate factors of financial distress.
1.2 Statement of the Problem
As we notice financial crises in the 1980s and 1990s sub–Saharan African banking, the 1997
and 1998Asian financial crisis and the 2007/08 financial crisis in the US, banks play an
important role in the economy. When banks are healthy, they efficiently allocate funds and
when banks are unhealthy, whether distressed or insolvent, this role is compromised (Betz, et
al., 2013). Even in recent period studies in Ethiopia show, at the beginning of the 2000s,
almost all banks were not that healthy since they were in the gray area which is an
intermediate zone between bankruptcy and a healthy zone. The zone of gray area is an
undesirable area of financial health that is characterized by financial distress than healthiness
(Ephrem and Nidu, 2015).

1
Central banks of Ethiopia raise Bank's minimum paid-up capital to ETB 5 billion within five
years from the existing ETB 500 million mandated in 2011. The experience of many
developed and developing countries shows that capital build-up improves the banking
industry's stability by creating well-capitalized banks which can withstand financial
instability. Regulatory capital beef up becomes globally common after the financial crisis
began in 2007 (Ethiopian business review, 2021). The central banks of Ethiopia stress the
move is necessitated by the need to improve financial reliance and ensure the soundness of
the banking industry; which is implicitly an indicator of financial distress in Ethiopian banks.
Despite their inconsistency, considerable empirical investigations had conducted in the area
of banking financial distress; however, as the sector has been characterized by rapid growth
and attractive accounting profit (Mullu, 2011); this couldn't guarantee they're going on
concern since accounting profit doesn’t equivalent with cash (Pranowo, et al., 2010), there
are limited recent studies in concerning the banking sector of Ethiopia. There are studies in
this regard recently few researches have been done with a limited sample size and sampling
period. To mention some: Ephrem (2015), Ephrem and Nidu(2015), Tadesse (2017), Goitom
(2019), Robel (2018), and microfinance institution Hargewayni (2017), and others.
Therefore, this research filled the literature gap regarding the Ethiopian banking sector and
contribute to the body of knowledge by incorporating more bank-specific factors; more study
period; including macroeconomic factors, which were not addressed by others; increasing the
sample size, to minimize the limitation of the previous study; and using the appropriate
model developed by Altman et al. (2000) for the developed non-manufacturing firm for
predicting banking financial distress.
1.3. Objectives of the Study
1.3.1. General objective
The main aim of this study will be to analyze the Financial Distress and their determinants of
selected private Commercial Banks in Ethiopia.
1.3.1. Specific objectives
 To examine the current financial distressed conditions of selected private Commercial
Banks in Ethiopia.
 To investigate the effect of determinants of financial distress condition of selected private
Commercial Banks in Ethiopia.
1.4 Literature-driven Hypotheses
After reviewing different relevant and related literature, the researcher hypothesizes that
liquidity, profitability, leverage, firm growth, efficiency, market share, inflation, and
 exchange rate were predicted to influence financial distress conditions which are measured by
the ZETA score (financial distress). Therefore, the following hypotheses concerning the
analysis of financial distress conditions and their determinants of the selected commercial
banks were tested.
If the profitability of the firm increases, the financial distress decreases. On the other hand,
the more unprofitable company, the higher probability of failing (Yohannes, 2014).
Therefore, there is a positive relationship between profitability and Zeta score as a proxy of
financial distress for the selected commercial Banks.

Hypothesis - 1:
Ho: Profitability has no positive and significant impact on the Zeta score of financial
distress of selected commercial Banks.
H1: Profitability has a positive and significant impact on the Zeta score of financial distress
of selected commercial Banks.
The more the firm is liquid; the less the probability of the firm's financial distress (sign+).
The higher the firm's liquid assets, the higher the ability of the firm is covering its fixed
charges and the lower the probability of the firm to go for financial distress (Yohannes,
2014). Therefore, there is a positive relationship between a firm's liquidity and Zeta score as a
proxy for financial distress.
Hypothesis - 2:
Ho: Liquidity has no positive and significant impact on the Zeta score of financial distress of
selected commercial Banks.
H1: Liquidity has a positive and significant impact on the Zeta score of financial distress of
selected commercial Banks.
The more the firm's debt means the more the probability of the firm's financial distress.
Bankruptcy is usually beginning with the default on debt servicing; thus, the higher the debt,
the higher the probability of default (sign -). If the higher the firm's leverage, the lower the
probability of its debt services coverage and the higher the probability of financial distress
(Yohannes, 2014). Therefore, there is a negative relationship between leverage and Zeta
score as a proxy of financial distress for the selected commercial banks
Hypothesis - 3:
Ho: Leverage has no negative and significant impact on the Zeta score of financial distress of
selected commercial Banks.
H1: Leverage has a negative and significant impact on the Zeta score of financial distress of
selected commercial Banks.

.The firm efficiency is measured in terms of turnover and operating income to operating
profit. Higher operating profits to total income mean lower expenses and higher total
operating income which means management is more efficient in terms of operational
efficiency.

Hypothesis - 4:
HO: Efficiency has no positive and significant impact on the Zeta score of financial distress of
selected commercial banks.

H1: Efficiency has a positive and significant impact on the Zeta score of financial distress of
selected commercial banks.

Most previous studies use the percentage change of assets as a proxy to measure growth. The
result shows that growth has a positively significant relationship to financial distress (Daniel,
2011)

Hypothesis - 5:
H0. The growth of a company has no positive impact on the Zeta score of financial distress of
selected Commercial Banks.
H1. The Growth of a company has a positive impact on the Zeta score of financial distress of
selected Commercial Banks.

A firm having a large market share is more efficient and its performance enhances and thus
less likely to be financially distressed. Factors such as ununiform expansions and intense
competition are probable causes of financial distress.

Hypothesis - 6:
H0. Market share of the company has no positive impact on Zeta score of financial distress of
selected Commercial Banks.
H1. Market share of the company has a positive impact on the Zeta score of financial distress of
selected Commercial Banks.

If the inflation is higher, the firm's debt services coverage is probably lower (expected sign -).
Therefore, there is a negative relationship between inflation and debt service coverage as a
 proxy for financial distress (Yohannes 2014).Therefore, there is a negative relationship
between inflation and the Zeta score of financial distress for the selected commercial banks.

Hypothesis - 7:
H0. Inflations have no negative impact on the Zeta score of financial distress of selected
Commercial Banks.
H1. Inflations have a negative impact on the Zeta score of financial distress of selected
Commercial Banks.

Research conducted by Osundina (2016) which is “Exchange Rate Volatility and Banks
Performance: Evidence from Nigeria” evident that further depreciation in the value of the
naira will lead to a fall in the liquidity position of the banks.

Hypothesis - 8:
H0. The exchange rate has no positive impact on the Zeta score of financial distress of selected
Commercial Banks.
H1. The exchange rate has a positive impact on the Zeta score of financial distress of selected
Commercial Banks.

1.5 Significance of the Study

The study is of great use to the government and national bank which regulates the banking
sector. The government will benefit by taking into consideration the determinant that will be
highlighted that cause financial distress. In this way, they will adjust appropriately to prevent
such occurrences. The finding and recommendations will enable bank stakeholders to know
about the causes which are determinants of financial distress and to take corrective measures;
while playing their vital role in banks. It also helps private commercial banks to predict their
future; since the situation of distress is not desirable and it lets gives chance to take
preventive measures before happens. Finally; it can serve as a reference for future studies on
this area in this country. This study could serve as reference material for both academicians
and researchers who can expound on the research gap which was created by the study. In
addition, the scholars will benefit from the theoretical and empirical literature generated by
the study on determinants of financial distress in corporate governance and financial
institutions.
1.6. Scope of the Study

The study is only considering the analysis of financial distress and its determinant factor of
selected private commercial banks in Ethiopia. To undertake this study, thirteen private
commercial banks have been used by the researcher. namely: Awash Bank, Dashen Bank,
Bank of Abyssinia, Wegagen Bank, United Bank, Nib International Bank, Cooperative Bank
of Oromiya, Lion International Bank, Zemen Bank, Oromia Bank (2008), Bunna
International Bank, Birhan Bank, Abay Bank. The research covers a period of ten years
(2011-2020). Since the research use panel data, it requires having a large number of
observations as much as possible. Consequently, the research was limited to those banks that
stayed more than ten years in the industry, during the sampling period. However, the research
excluded two state-owned banks the Development Bank of Ethiopia (DBE) due to its unique
nature and the commercial bank of Ethiopia (CBE) for its incomparable large size with the
remaining banks.

The study uses the new revised Altman z score (Z” score) as a proxy for financial distress and
the study was limited to the following variables: five firm-specific determinants of Finical
distress that is Leverage; profitability; Liquidity; firm growth, efficiency, and three
macroeconomic determinates which is the Exchange rate, Inflation rate, and market share.

1.7 Limitation of the Study

1.8 Organization of the Study

This study will be compiled in to five chapters. The first chapter deals with introduction. The
second chapter will take the review of the related literature. Chapter three will be the research
design and methodology. Chapter four will elaborate data analysis and discussion. Finally,
chapter five will state summary of major findings, conclusions, and recommendations.
CHAPTER TWO
REVIEW OF RELATED LITERATURE
This chapter deals with the literature review part of the research report. It contains the review
of available literature in the area of financial distress of firms in general and banks in
particular. It has two parts; the first part contains theoretical literature of financial distress.
And the second part deals with the empirical literature of financial distress. In the second part
of the literature, the empirical literature of financial distress is presented in Global, African
and Ethiopian context respectively.

2.1Review of Theoretical Literature

2.1.1History of Banking Industry in Ethiopia

The 1905 agreement reached between Emperor Minilik II and Mr. MaGillivray,
representative of the British owned National Bank of Egypt marked the introduction of
modern banking in Ethiopia. Following the agreement, the first bank called Bank of Abysinia
was inaugurated in Feb.16, 1906 by the emperor. The Bank was totally managed by the
Egyptian National Bank and the following rights and concessions were agreed upon the
establishment of Bank of Abyssinia: (History of Banking - National Bank (nbebank.com)

Bank of Ethiopia took over the commercial activities of the Bank of Abysinia and was
authorized to issue notes and coins. The Bank with branches in Dire Dawa, Gore, Dessie,
Debre Tabor, Harar, agency in Gambella and a transit office in Djibouti continued
successfully until the Italian invasion in 1935. During the invasion, the Italians established
branches of their main Banks namely Banca d’Italia, Banco di Roma, Banco di Napoli and
Banca Nazionale del lavoro and started operation in the main towns of Ethiopia. However,
they all ceased operation soon after liberation except Banco di Roma and Banco di Napoli
which remained in Asmara. In 1941 another foreign bank, Barclays Bank, came to Ethiopia
with the British troops and organized banking services in Addis Ababa, until its withdrawal
in 1943. Then on 15th April 1943, the State Bank of Ethiopia commenced full operation after
8 months of preparatory activities. It acted as the central Bank of Ethiopia and had a power to
issue bank notes and coins as the agent of the Ministry of Finance. In 1945 and 1949 the
Bank was granted the sole right of issuing currency and deal in foreign currency. The Bank
also functioned as the principal commercial bank in the country and engaged in all
commercial banking activities.(History of Banking - National Bank (nbebank.com)

The first privately owned bank, Addis Ababa Bank Share Company, was established on
Ethiopians initiative and started operation in 1964 with a capital of 2 million in association
with National and Grindlay Bank, London which had 40 percent of the total share. In 1968,
the original capital of the Bank rose to 5.0 million and until it ceased operation, it had 300
staff at 26 branches.

2.1.2 Financial Distress

Since first devoting its attention to the subject, academic literature has emphasized the
difficulties in defining corporate financial distress because of the incomplete and arbitrary
nature of any criteria by which to classify it. Scholars have defined financial distress in
different ways. According to Altman (1993) failure, insolvency, default and bankruptcy are
four different terms and they all mean that a firm is in distress. Failure, by economic criteria,
means continues decline in return from invested capital as compared to similar investment
and risk level. According to Altman (2006) business failure includes businesses that cease
operation following the assignment or bankruptcy; those that cease with loss to creditors after
such actions or execution, foreclosure, or attachment; those that voluntarily withdraw, leaving
unpaid obligations, or those that have been involved in court actions such as receivership,
bankruptcy reorganization, or arrangement; and those that voluntarily compromise with
creditors.

Still financial distress is hard to define precisely. This is true partly because of the variety of
events befalling firms under financial distress (Stephen et al, 2012). “Financial distress is a
situation where a firm’s operating cash flows are not sufficient to satisfy current obligations
(such as trade credits or interest expenses), and the firm is forced to take corrective action.
Financial distress may lead a firm to default on a contract, and it may involve financial
 restructuring between the firm, its creditors, and its equity investors. Usually, the firm is
forced to take actions that it would not have taken if it had sufficient cash flow” (Stephen et
al, 2012).

2.1.3 Financial Distress Prediction

The prediction of company’s survival is essential for management and company owners to
anticipate the possibility of potential bankruptcy. Predicting bankruptcy is a difficult exercise
and many challenges have to be faced. The first challenge starts with the selection of the
technique to be used.
After wide literature review made by (Francois van Der Colff and Frans Vermaak, 2015)
cited in (Robe, 2018) have pointed financial distress prediction methods to three main
categories, i.e., classical statistical models, artificially intelligent expert system models, and
theoretical models.

A. Classical statistical models

Univariate Model, Risk Index Model, Multiple Discriminates Analysis, and Logit and Probit
analysis are commonly known type of classical statistical models around.

Univariate:- The univariate model has ability to classify as failed and non- failed company
accurately five years before failure. This model was initially built by (Beaver, 1966) to
predict company failure using different financial ratios of paired (failing and non-failing)
samples. And disclosed three significant financial ratios to predict financial distress: Total
Debt / Total Assets (Debt ratio) Net Income / Total Assets (returns on assets) and Cash
Flow / Total Debt (HELLEN, 2013).

Risk Index:- This model was developed by (Tamari, 1966) to disprove the Univariate model
developed by (Beaver,1966).It includes some different ratios as generally accepted as a
measure of financial health of firms. Then he listed down firms with the higher value of the
ratios calculated to lower. The firm with high ratio total indicated has considered as a
company with better financial position or situation. But there are questions often asked about
this model; ‘the multi co-linearity of ratios used’; since there may be double counting of
ratios can be existed (Helen, 2013).

Multiple Discriminates Analysis:- was the first financial distress predictor developed by
Altman in 1968. He used several financial ratios to address the very limitations of both
Univariate and Risk index model developed previously. In an effort to address the question of
the predictive accuracy of univariate analysis, he converted a univariate analysis to multiple
discriminate analyses (MDA). The MDA’s strength lies in its ability to measure company’s
financial attributes by analyzing several ratios simultaneously, as well as the interaction
between these ratios. Z-Score model has become a popular and widely accepted measure of
financial distress. He concluded that if the discriminator model was used correctly and
periodically, it would be able to predict company financial distress early enough to enable
management to realize the extent of the distress in time and consider corrective action to
avoid failure (HELLEN, 2013).

Logit and Profit analysis: (Harrison, 2005) is who mainly employed it after extending the
work of (Ohlson’s 1980) trial. Logit regression is used to predict the result of categorical
dependent variables and independent variables (Judy et al, 2015). Whereas; Probitregression
refers a model of binomial response variables. Like others the aim of the author is to
overcome the limitations of previously developed models: Univariate, Risk-Index and MDA.
Selective ratios are used to forecast the financial conditions of firms but the numbers of ratios
are limited and difficult to conclude.

Rough sets model: - the aim of rough sets theory is to classify objects using imprecise
information. In this model, knowledge about the objects is presented in an information table
that, in effect, works like a decision table containing sets of condition and decision attributes
that is used to derive the decision rules of the model by inductive learning principles. Every
new object (for example, a firm) can then be classified (healthy or in financial distress) by
matching their characteristics with the set of derived rules.

C. Theoretical models
Aziz and Dar (2006) have identified the following theories that have been used to substantiate
bankruptcy predictive models.

Trade-off theory:- addressed the impact of financial distress on the capital structure
decision. The underline premise of this theory is that a firm will identify an optimal target
capital structure that they believe balances the benefits of the tax shield against the cost of
distress. The trade-off theory underlines that although the tax benefit of debt will cause the
value of a firm to increase as leverage is increased, this will only be true to a point since
leverage increases, so too does the likelihood of default. The cost of financial distress
eventually becomes so great that it erodes the benefits of the tax shield, and firm value begins
to decline. The implication is that there is an optimal debt level.

Entropy theory:- The Entropy theory or the Balance Sheet Decomposition Measure theory
dictates that it is possible to identify the potential risk of financial distress by carefully
looking at changes in their balance sheet (Aziz and Dar, 2006).Entropy theory employs the
Univariate Analysis (UA) and Multiple Discriminate Analysis (MDA) in examining changes
in the structure of balance sheets. According to this theory, if a firm is not capable of
maintaining equilibrium state in their balance-sheet component (Asset and liability) and is not
able to control in near future, it is more likely to foresee distress (Aziz and Dar, 2006).

Cash management theory:- The proponent of cash management theory dictates that firm
has to manage the cash inflows and outflows to avoid fund imbalance. According to Aziz &
Dar (2006) persistent fund imbalance between cash inflow and cash outflows, which emanate
from failure of cash management function of the firm, will resulting financial distress and,
then, may lead to business failure.

Gambler’s Ruin theory:- Gambler Ruin theory, which was developed by Feller in 1968, is
based on the probability of a gambler wins/loses of money by chance. The firm can be
considered as a gambler playing repeatedly with some probability of loss, continuing to
operate until its net worth/capital goes to zero. With an assumed initial amount of cash, in any
given period, there is a net positive that a firm’s cash flows will be consistently negative over
a run of periods, ultimately leading to bankruptcy (Aziz and Dar, 2006).
Credit risk theory: - This theory is closely related to financial institutions. According to this
theory the firm will face credit risk, which emanates from failure of debt holders to pay the
amount owed when it comes due, that would prone the firm to financial distress and then
business failure (Nyunja, 2011).

2.1.4 Determinants of Financial Distress

In line with the stated objective the following determinants of financial distress have
identified from literatures.
2.1.4.1. Bank Specific Factors
Profitability
In competitive markets, firms need to generate positive profits in order to survive. Firm
profitability has linked to financial distress and bankruptcy in two ways. First, firms with
poor management will ultimately be driven out of the market by more able management
teams. Second, in the absence of a large reserve cushion, the lack of profits will ultimately be
associated with low levels of liquidity. Here again, the researcher follows Altman (1968) in
using the ratio of gross profit to total sales to proxy for firm level profitability.
Efficiency
Management efficiency is the most important ingredient that ensures the sound functioning of
commercial banks. In competitive financial sector, efficiency and effectiveness have become
the rule as banks constantly strive to improve their productivity. Presently it is common to see
branches of banks both public and private maintaining extended working hours, flexible time
schedules, outsourcing marketing etc. to attract customers. Thus, managerial competence of a
bank is an important determinant of profitability, while contributing to the long-term survival
of the bank, even under distress (Sahut and Mili, 2011).

Liquidity
There should be adequate liquidity, compared to present and future needs, and availability of
assets readily convertible to cash without undue loss. The fund management practices should
ensure that a bank is able to maintain a level of liquidity sufficient to meet its financial
obligations in a timely manner; and capable of quickly liquidating assets with minimal loss.
The liquidity ratio expresses the degree to which a bank is capable of fulfilling its respective
obligations. Banks makes money by mobilizing short-term deposits at lower interest rate,
and lending or investing these funds in long-term at higher rates, so it is hazardous for banks
mismatching their lending interest rate.
Bank size
Regarding bank size literature provides a contradicting view. On one hand, Bongini et al.
(2001) argue that in terms of probability of financial distress, a large financial institution
might have lower chance of becoming distressed if it is more diversified and less exposed to
liquidity shocks. On the other hand, according to the “too-big-to-fail” hypothesis the
likelihood of distress increases for big banks due to a guarantee provided from government at
a time of insolvency. This support exposed large banks to take excessive risks, which is more
than they can afford to lose, in an effort to maximize earnings (Iannotta, et al., 2007).
Leverage
Another determinant of financial distress is firm leverage. Once again, the theoretical
underpinning for leverage as a predictor of distress lies in the fact that leverage limits the
ability of the firm to withstand negative shocks to cash flow. Following Altman (1968) the
researcher uses the ratio of total liabilities to total assets to control for the impact of leverage
on distress. The other causes of financial distress are increased leverage ratio, which is the
measure of how heavily the firm is indebted. The reason for risk is the prevalence of fixed
cost. Leverage is the use of debt financing, and the leverage ratios are measures of the
relative contribution of stockholders and creditors, and of the firm's ability to pay financing
charges (Lico Junior 2000).

2.2 Empirical Literature Review

This part deals with the empirical framework supported by different researchers regarding the
financial distress determinants.

2.2.1 Empirical literature on financial distress in Global context

Altman (1968) conducted studies on financial distress and bankruptcy. The researcher had
been continuously conducting researches in the area of distress and distress classification
model, and to develop improved model for bankruptcy prediction. The researcher first
developed a Z score model which is widely accepted distress sorting model. His prediction
method applied discriminating function by linear regression model where Z is overall index
and other financial variables to be independent variables such as: working capital/total assets
retain earning/total assets, earnings before interest and tax/total assets, book value
equity/book value of total liabilities and sales/total assets. As per researcher finding Z-Score
model is very accurate to predict failure and useful to suggest the causes of financial distress.

Altman (2000) made study on predicting financial distress of companies: Revisiting the Z’’
score and Zeta models. As per researcher findings, the following three situations are
considered for studying the financial health of developing non-manufacturing firms. The first
situation shown the “Z” score below 1.1 units is considered to be bankruptcy zone. Failure is
certain and extremely likely and would occur probably in two years. The second situation
indicate if a units Z’’ score is 1.1 or above but less than 2.6, its financial viability is
considered to be a gray area. The failure in this situation is uncertain to predict. The last
situation refers the Z‟ scores above 2.6 indicates healthy zone. Its financial health is very
viable and would not fall.

2.2.2 Empirical literature on financial distress in African context

According to (Yauriet al, 2012), who investigated the effect of recapitalization on Nigerian
banking distress, concluded that increasing minimum capital requirement had only accounted
for a short-term improvement in the liquidity position of banks and improvement in their
asset quality but were not have long-term effect on forestalling distress. Therefore, they had
recommended improving bank corporate governance to prevent future occurrence of the
threat of distress in the banking sector, which is also consistent with the findings of (Baklouti
et al, 2016).

Leroi (2014) made study on disaggregated credit extension and financial distress in South
Africa. The study analyzed the relationship between disaggregated credit extension and
financial distress in South Africa. Financial distress was measured as the composite indicator
comprising the variables that cover the main segments of the South African financial market,
including bond and equity securities markets as well as the exchange rate market. Principal
components analysis weighting scheme was used in the construction of the composite
indicator financial distress. Bayesian Variable Selection was then used to uncover the co-
movements between disaggregated credit extension and the financial distress indicator. The
empirical results generally provide evidence that the aggregate measure of credit extension
has a robust and positive relationship with the composite measure of financial distress, while
such a relationship is mixed for the disaggregated components of credit extension. to
government sector.

2.2.3 Empirical literature on financial distress in Ethiopian context

Andualem, (2011) also conducted research on “the determinants of financial distress of
selected firms in beverage and metal industry of Ethiopia”. His study estimated determinants
of financial distress using panel data starting from 1999 to 2005. He used sample of 68
companies selected out of 116 share companies in the beverage and metal industry of
Ethiopia. The results show that profitability, firm age, liquidity and efficiency have positive
and significant influences to Debt Service Coverage (DSC) as a proxy of financial distress.
On the other hand, leverage has a negative and significant relation with DSC. On the other
day; he also tried to see overall manufacturing firm’s situation in Ethiopia for the period from
1999 to 2005 by taking debt service coverage ratio as main proxy in addressing financial
distress. Based on panel data General Least Square (GLS) regression method used: liquidity,
profitability, and efficiency had positive and significant influences on debt service coverage.
On contrary, leverage has negative and significant influence on Debt Service coverage.
Ephrem, G., (2015) studied the determinants of financial distress conditions of commercial
banks in Ethiopia a case study of selected private commercial banks by using Altman Z score
model and estimated determinants of financial distress using panel data. The study includes
six private commercial banks in Ethiopia in the sample and data collected from 2002/03 to
2011/12. The researcher used only bank specific factors that affect firm’s financial distress.
In the study Altman’s’ Z score of the banks is used as the proxy for financial distress as it
measures the financial distress conditions of banks and the study also used non-performing
loan, the ratio of interest income to total revenue, capital adequacy, firm efficiency and firm
size as an independent variable. The findings of the study confirms that capital to loan ratio,
net interest income to total revenue ratio have statistically significant positive influence on
the financial health of banks whereas the non-performing loan ratio has statically significant
negative influence on the financial health of the banks.

2.3 SUMMARY OF LITERATURE REVIEW AND RESEARCH GAP

The review literatures showed that most of the studies conducted on the banking and
insurance companies use Altman z score model of 1993 and most of the studies conducted on
manufacturing firm use Debt service coverage as a proxy for financial distress conditions. As
per the review, more research is done on manufacturing sectors, microfinance institutions and
in insurance companies in Ethiopia. However, there are studies conducted on Bank industries,
but most of these studies focused only on firm specific factors that affect the financial distress
condition of commercial banks in Ethiopia.

Moreover, the literature review also reveals the existence of controversial conclusions that
results from different studies made so far and also some unexpected result was appear in the
study. For instance, Andualem (2011) and Yohannes (2014) use debt service coverage as
proxy for financial distress, but profitability and efficiency have different significance impact
on both studies. Goitom (2019) conducted its research on both bank and insurance companies
with a very limited sample study conclude un expected result, which is efficiency was a
negative significant influence on financial distress. Finally, Tadesse (2017) incorporate more
variable than previous studies. However, Altman 1993 model of financial distress for
emerging market was uses for his study: which was not the appropriate model for the study
and again there was a significant contradiction in his descriptive statistics and the regression
output.
 As per the researcher empirical investigation there is considerable researches that have been
done in the area of financial distress of financial institutions around the world, there is no
sufficient research in this area as far as the financial sector of Ethiopia is concerned. To best
of the researcher knowledge, there is only few attempts was made by Ephrem (2015),
Tadesse (2017 and Goitom (2019). Therefore, this research aimed to fill the gap observed in
the previous study while contributing to the body of knowledge. Specifically, the research is
different in the following dimensions:

 By incorporating all private commercial banks operating for at least ten years.
 By incorporating both firm specific and macroeconomic factors other than gross domestic
product and Inflations that determine financial distress of commercial banks in Ethiopia.
 the study employed an appropriate model developed by Altman et al. (2000); which is the
revisit model designed for developed non-manufacturing firm.

2.4 CONCEPTUAL FRAME WORK

Based on above empirical work of literature reviews the researcher adopts the following
conceptual frame-work;
Independent variables Dependent
variables

Firm specific Factors Safe zone

 Profitability Z score > 2.6

 Liquidity
 Leverage Financial
 Firm growth distress
 Efficiency Gray zone

(Altman’s Z 2.6< Z score >1.1

Macroeconomic factors score)

 Market share
 Inflations
 Exchange rate
Source: Self constructed

CHAPTER THREE
3. RESEARCH METHODOLOGY
This chapter sets to explain the research design, target population, sampling size and
sampling method, methods of data collection and data source, data analysis and techniques,
and also the operational definition of variables and model specifications were presented

3.1 Research Design

“A research designs the arrangement of conditions for collection and analysis of data in a
manner that aims to combine relevance to the research purpose with economy in procedure.
The research design is the conceptual structure within which research is conducted; it
constitutes the blueprint for the collection, measurement, and analysis of data" (Kothari,
2004).

Depending on the nature of the research problem and the research perspective, a research
method could be based on the philosophy of quantitative or qualitative or a combination of
these two approaches.

Therefore, for this study quantitative research approach was used to see the relationship
between
the financial distress (Z” – score of Altman’s2000 model, for the developed non-
manufacturing firm) of private commercial banks through specific and macroeconomic
determinants. To address a broader range of the subject and tackle more complex problems
that would be possible with either pure time-series or pure cross-sectional data. Thus, the
study will also adopt an explanatory research approach by using a balanced panel research
design to meet the research objective.
3.2 Data type and Source

The researcher employed quantitative data type which is gathered from annual audited
financial statements and annual reports of the National Bank of Ethiopia. To collect the
necessary data for this study, a secondary data source was used. The secondary data was
derived from the financial statements of the selected commercial banks in Ethiopia (from
2011 up to 2020). The data included an audited Financial Statement including a Balance
sheet and income statement. The specific variables of the study data were driven from the
annual report of the selected commercial banks of Ethiopia. Macroeconomic determinants
data used for the study were obtained from the National Bank of Ethiopia (NBE).

3.3 Sampling Procedure

3.3.1 Target population

The target population in this study covers all commercial banks that are operating in Ethiopia.
That means, it covers 27 banks registered and operated in Ethiopia (NBE, 2021) out of which
two are state-owned banks, namely Commercial Bank of Ethiopia and Development Bank of
Ethiopia.

3.3.2 Sample Technique

The researcher needs to have a large sample size to get more accurate results and have a high
likelihood of detecting a true result. Thus, the researchers used the Purposive sampling
method. Besides, since the number of banks in the country is too many to incorporate in this
study and due to the data nature (panel data), the sample should contain all private
commercial banks that have at least 10 years of age (2011 to 2020) and all the state-owned
banks will be excluded due to the size and market share domination. Here, the advantage of
using panel data is under consideration, that is controls for individual heterogeneity, less co-
linearity variables, and tracks trends in the data something which simple time-series and
cross-sectional data cannot provide (Brooks,2014).

Therefore, out of the 25 private commercial banks resisted in NBE, only Thirteen (13) are old
enough to be taken for ten years of data analysis. Ten years of data is used for the analysis is
ordered to increase the number of observations and to get a somehow accurate result.

3.4. Methods of Data collection

As per the research objectives, the researcher mainly uses secondary sources of data. The
secondary data of the respective private commercial banks were collected from the Audited
financial statement and macroeconomic variables from the National bank of Ethiopia
research study office for ten consecutive years (2011-2020). The method adopted to collect
the necessary data consists of structured document reviews.

3.5 Data Analysis Techniques

Data analysis is a systematic process that applies statistical techniques to evaluate data
through inspecting, transforming, and modeling data to draw useful information or decision
making. To test the financial distress condition of private commercial banks in Ethiopia,
Altman’s Z’’-score model for the developed non-manufacturing firm was used.

To test the numerical relationship between the dependent variable (i.e., financial distress
condition) and the independent variables (i.e., profitability, liquidity, leverage, efficiency,
firm growth, inflation, market share, and exchange rate), the researcher uses the random
effect multiple regression analysis will be used.

3.6 Model Specification

The study first assessed the financial distress condition of selected private commercial banks
in Ethiopia by using the Altman’s Z” score model. Altman’s Z” score analysis has been
applied by financial analysts to evaluate the general trend in the financial health of the firms
over a period by applying Multiple Discriminate Analysis (Altman, 2000).

The data collected are first analyzed with the help of four accounting ratios. These different
ratios were combined into a single measure, Zeta score analysis with the help of Multiple
Discriminate Analysis (MDA). The new revised formula is used for financial firms like the
Banking industries to evaluate the Zeta score analysis as established by (Altman, 2000).
Various researches have been conducted using this model by applying Multiple Discriminate
Analysis (MDA). Some of the researchers who used this model in their research include;
(Goitom, 2019), (Haregewayin,2017), (Tadesse,2017), (Hamdala,2016), and (Ephrem,2015).

In the year 2000, Edward I. Altman revised his bankruptcy prediction model and developed a
new Z-score model which can be applied for predicting the financial distress condition of
developed non-manufacturing firms.

Altman 𝒁′′ − 𝒔𝒄𝒐𝒓𝒆 = 𝟔.𝟓𝟔𝑿1+ 𝟑.𝟐𝟔𝑿2+ 𝟔.𝟕𝟐𝑿3 + 𝟏.𝟎𝟓𝑿4

Where: Z’’= financial distress score of banks as measured by Altman model,

X1= Working capital/total assets,

X2= Retained Earning/total assets,

X3= EBIT/total assets and

X4= Book value of equity/total debt.

If the “Z” scores level of a firm is:

  > 2.6 the firm is in the "safe zone"
 Between 2.6 and 1.1 the firm is in the “Gray zone”
 < 1.1 the firm is in the “Distress zone “

3.7 Econometric Model

Based on the theoretical and empirical, the study comes up with the following model,
variables that were tested to meet the research objectives, identifying the determinants of
banking distress.

FDi, t=βo+β1(PRO)i,t+β2(LIQ)i,t+β3(LEV)i,t+β4(EFF)i,t+β5(FGR)i,t +β6(MSH)i,t + β7(INF)i,t

+β8(EXR)i,t + εi,t
Where:
βo: is constant i: number of Banks. t: number of periods.
β1, β2, β3, β4, β5, β6, β7and β8 are coefficients of independent variables.
FD is a dependent variable is the output of the “Z" Score
PRO is representing profitability and is measured as operating income to total assets.
LIQ refers to liquidity and it is measured as a total current asset to total current liabilities.
LEV is indicating leverage and it is measured by total liabilities to total assets.
EFF is the Banks management efficiency ratio as a measure of total expenses incurred to total
income received.
FGR is the growth of a company as measured percentage change of total assets.
MSH is the percentage of each selected Bank's market share among all commercial Banks
INF is referring to inflation
EXR is the dollar exchange rate volatility over the year and
ε is an error term
3.8 Variable Descriptions

3.8.1 Dependent variables

In the literature, there are various alternatives to measure the financial distress of the firms;
which includes Moody's financial ratio, standard and Poor's financial ratio, Vasari’s financial
ratio, logit model, and Altman's Z-score. According to Vaziri et al., (2012), study the
comparative predictability of failure of financial institutions using multiple models, of all the
models Z-score model gives the best prediction. Its prediction percentage of failed financial
institutions is 80% and shows 75% correct prediction before two years.
Therefore, in this study Z” score of the banks under the study is used as the dependent
variable to measure firm financial distress.

3.8.2 Independent Variables

To measure the predictor variables of financial distress of commercial banks in Ethiopia,
eight variables were used as independent variables which are extracted from different studies.
The independent variables or determinants of financial distress were profitability, leverage,
efficiency, liquidity, firm growth, Market share, Exchange rate, and inflation. These variables
can be measured by the following formulas:

Work plan and budget breakdown

Work plan
Activities Duration Final Date
Selection of research title. December January, 2022
Preparation for proposal work and February February , 2022
gathering information used.
Contact with advisor and working of February June 2022
proposal.
Doing and research proposal February February 2022
submission.
Gathering data for research paper and March to June June 2022
contact with advisor and completion
Finalize research paper and submission June 2022 June .2022

Budget breakdown

Table below will show estimated cost to complete the research study

1 Stationery Items
1 Material expected for work. Unit Quantity Unit Price Total cost
Printing paper Pkt 4 120 480
Photo copy paper Pkt 2 120 240
Toner Cartridge Pcs 1 1400 1400.00
 CD (CR-RW) Pcs 10 25 250.00
Flash Disc (USB) Pcs 1 400 400.00
CDMA(USB) Pcs 1 1400 1400.00
Pen Pcs 5 10 50.00
Pencil Pcs 8 5 40
Marker Pkt 2 75 150.00
Note Book No 1 150 150.00
Sub- total 4585
2 Transport
Category Unit Quantity Unit price Total cost
1 Home to various banks Trip 10 100 1000.00
2 From various banks back tp home Trip 10 100 1000.00
Sub –total 2,000.00

3 Miscellaneous Expenses
1 Photo copy Pages 32 2 64
2 Binding 500
3 Communication (Telephone, internet, etc.) 500
4 Sub total 1064

Total budget summary for research study.

No Category Total expenses (Birr)

1 Stationery 4585
2 Transport 6000
3 Miscellaneous expenses 3,150.00
4 Total 13735
4 Contingence expenses (10%) 13735( 13735*0.1)
5 Total Budget 15108.50
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