Financial Leverage and Firm Response to Poor Performance

This study tests the relationship between financial leverage and a firm's operational and financial short term responses to poor performance, based on Jensen's (1989) argument that higher predistress leverage increases a firm's incentive to respond more quickly to poor performance. This research is conducted on a sample of 45 poorly performing New Zealand firms between 1985 and 1994. The results indicate that higher leverage increases the probability of firms taking action in the short term. In particular, the evidence suggests that the probability of asset sales is positively associated with long‐term leverage, in addition to its relationship with the firm's stock return. Increased probability of management replacement is related to higher levels of short‐term leverage and surprisingly, the probability of dividend cuts decrease with higher levels of total and short‐term leverage. Poorly performing firms with higher leverage also appear to cut asset levels and dividends more aggressively than those with lower leverage levels.