Sensitivity and Sectorial Analysis to examine the impact of Risk on Performance Of Firms

1. Introduction:

1.1 Over view:

Financial decisions have influencing role in determining their investment activities. To perform
investment activities firms’ usually have three main sources of financing i.e. internal financing
that includes retained earnings and external financing which includes debt and equity financing.
Firms’ need finance to grow either by generating it internally or to have access to external
sources of finance accordingly their financial policy (Bhagat et al. 2005). But in general, there
comes a situation for firms which are not internally constrained where only internally generated
funds i.e. cash flows are not enough to finance in investments which seem to be valuable in
future. Thus, these firms need external sources of finance to increase their investments level by
investing in profitable opportunities.

Imperfections in Capital market lead to information asymmetries between lender and borrower as
lender do not have fully information about borrower firms’ investment projects thus these firms
are charged with higher risk premium for external financing by lenders, Bond and Meghir (1994)
and Kaplan and Zingales (1997) and Fazzari et al. (1998). In case when internal funds are
insufficient to meet their expenses due to these market imperfections, consequently financial
constraints come in to existence in financial markets Guariglia (2008)3 . Thus, firms are called
internally financially constrained when they have to rely initially upon internal funds or financial
constraints can either be defined as the barriers that refrain firms to employ funds for their
investments. Whereas firms are said to be externally constrained for the reason that firms find
external financing costly. Firms which do not have access to external funds become financially
constrained so these firms keep check upon their cash flows to progress further. Whereas, firms
that have access to financial markets are financially unconstrained firms and normally use mixed
pattern of financing. At first Cash flows have considerable part in determining investment
behavior of both constrained and unconstrained firms because initially firms are dependent upon
their internal funds for investment activities so firms are initially to be called constrained when
they do not have access funds. The probability of financial constraints in firms rises with the
higher debt and decreases with the higher capital stock (Kai Kirchesch 2004)4 . External finance
premium depends on the level of debt and as well as capital stock of the firm. Thus, a higher
level of debt will increase external finance premium and a superior capital stock will decrease
this premium. The provision of finance from external sources i.e. banks and capital markets
depends upon firms’ specific characteristics like assets base, risks involved, financial strength
and performance due to the risk averse nature of financial institutions.

Concerning all the mechanisms discussed above, Literature in case of Pakistan is limited to
explore the internal financial constraints among firms and their sensitivity towards firms’
investment. Concerning all the mechanisms presented above, this study will observe financial
constraints and their impact on investment behavior of firms of manufacturing sector.

Performance measurement is a very important aspect of every business activities. The objective
of measuring performance does not only cover how a business is performing but also gives an
insight on how business can perform better. It helps to improve the overall performance of an
organization so as to ensure stakeholders achieves their various objectives.

Firm performance has been the most important issue for every organization. It is very important
for managers to know which factors influence firm’s performance in order to take appropriate
steps to initiate that factors (Abu-Jarad, I.Y., N. Yousof and D. Nikbin, 2010). However Ofley
(2003) stressed the importance of performance as financial measure as a tool of financial
management, main goal of an organization, and a means of motivating and controlling activities
within an organization.

No economic subject or an enterprise can predict the results of financial, investment or other
decisions in business because every activity and decision is risky (Shim and Siegel, 2008) on
global market. Risk is the category that affects business existence and performance (Sitek, 2013).
Risk is defined as anything that can create hindrances in the way of achievement of certain
objectives. It can be because of either internal factors or external factors, depending upon the
type of risk that exists within a particular situation. Managing risk is one of the basic tasks to be
done, once it has been identified and known. The risk and return are directly related to each
other, which means that increasing one will subsequently increase the other and vice versa. And,
effective risk management leads to more balanced trade-off between risk and reward, to realize a
better position in the future (Fatemi and Fooladi, 2006).
Financial risk is often defined as the unexpected variability or volatility of returns and thus
includes credit risk, liquidity risk, and market risks (Holton, 2004). In the classification of
business risks, it is necessary to pay attention to the risks that come into models of calculating
cost of equity and subsequently in the calculation models of business performance. For
calculation of discount rate for the valuation of the enterprise and its performance is necessary to
define the risks of business activity. The basic breakdown is as follows (Marik, 2011): business
and financial risk, systematic and unsystematic risk on the market were investigated in empirical
studies by (Olibe et al., 2008; Lopez-Espinosa 2013; Vicente 2015).

A risk that represents about an investment that has less marketability or that cannot be sold early
in order to protect from potential loss is named as liquidity risk. The point and time when certain
liquidity featured investment pinches to face subordinate composition against these investments
are elaborated as investment under liquidity risk. Liquidity risk forces entire entity to execute
alternative decision rather than investment conversion into cash. Liquidity risk parameters are
widely investigated scientifically. Liquidity risk depends upon liquidity risk management (LRM)
strategies regarding global and domestic environment, majorly on proportionate of prime
deposits (Correa, Goldberg and Rice, 2014).

Financial risk can be evaluated through indicators: Debt/Equity, EBIT (Earnings before interests
and taxes) / interest expense, loan repayments from Cash Flow, share of net working capital on
current assets, current ratio and quick ratio, Average Collection Period, average period of
inventories. The methods of analyzing and quantifying of the risk are well known statistical tools
and techniques to express numerical level of risk (Fotr and Soucek, 2011).

The objective of this study is to examine the impact of risk factors on firm performance evidence
from non-financial listed firms of Pakistan. For measuring the firm’s performance seven major
factors will be used. These factors are Business Risk, Financial Risk, Liquidity Risk,
Munificence, Dynamism and HHI.

The firm performance will be measured by all those above mentioned factors along with the
tools of Return on Assets (ROA) and Return on Equity (ROE).

Sensitivity analysis
A sensitivity analysis determines how different values of an independent variable affect a
particular dependent variable under a given set of assumptions. This technique is used within
specific boundaries that depend on one or more input variables, such as the effect that changes in
interest rates (independent variable) has on bond prices (dependent variable).

Sectorial analysis

Sector analysis is an assessment of the economic and financial condition and prospects of a given
sector of the economy. Sector analysis serves to provide an investor with a judgment about how
well companies in the sector are expected to perform.

Sector analysis is typically employed by investors who specialize in a particular sector, or who
use a top-down or sector rotation approach to investing. In the top-down approach, the most
promising sectors are identified first, and then the investor reviews stocks within that sector to
determine which ones will ultimately be purchased. A sector rotation strategy may be employed
by investing in particular stocks or by employing sector-based exchange-traded funds.

1.2. Background of study:

Risk is defined as anything that can create hindrances in the way of achievement of certain
objectives. (Arif and Anees, 2012) undertook a research on liquidity risk and its effects on banks
profitability in Pakistan. The research found that there existed significant negative relationship
between liquidity, deferred loans, liquidity gap and profitability. In a similar research done by
(Ahmed and Ahmed, 2012) where 22 banks in Pakistan were used for the period 2004 to 2009.
The findings were that profitability was positively correlated with liquidity gap similarly Chen,
(Shen and Kao, 2010) studied the pattern of liquidity risk of bank on performance for
commercial banks in 12 advanced economic countries for the years 1994-2006 and found that
liquidity risk is a determinant of bank performance. (Alper and Anbar, 2011) examined special
and macroeconomic determinants of Turkey's bank for the years 2002-2010 using panel data and
found that liquidity had positive effects on the bank's performance. This is consistent to (Naser,
Mohammad and Ma'someh, 2013) based on 15 banks of Iran during the years 2003-2010
liquidity risk had a significantly negative effect on performance.

(Arif and Anees, 2012) undertook a research on liquidity risk and its effects on banks
profitability in Pakistan. The research found that there existed significant negative relationship
between liquidity, deferred loans, liquidity gap and profitability. In a similar research done by
(Ahmed and Ahmed, 2012) where 22 banks in Pakistan were used for the period 2004 to 2009.
The findings were that profitability was positively correlated with liquidity gap similarly (Chen,
Shen and Kao, 2010) studied the pattern of liquidity risk of bank on performance for commercial
banks in 12 advanced economic countries for the years 1994-2006 and found that liquidity risk is
a determinant of bank performance. (Alper and Anbar, 2011) examined special and
macroeconomic determinants of Turkey's bank for the years 2002-2010 using panel data and
found that liquidity had positive effects on the bank's performance. This is consistent to (Naser,
Mohammad and Ma'someh, 2013) based on 15 banks of Iran during the years 2003-2010
liquidity risk had a significantly negative effect on performance.

(Arif and Anees, 2012) undertook a research on liquidity risk and its effects on banks
profitability in Pakistan. The research found that there existed significant negative relationship
between liquidity, deferred loans, liquidity gap and profitability. Financial risks have a great
impact on firm’s performance. (Jamal A. Noor and Abdalla, 2014)

(Kiseľáková D., Horváthová J, 2015) .The aim of this article is the analysis of impact of selected
systematic and unsystematic risks to performance of the enterprises. He used secondary data of
financial statements the selected company, which is representative of the Slovak food industry.
He conclude that the most significant impact on performance of the enterprise has just financial
risk. According to our calculations, it was confirmed that the unsystematic risks have a higher
impact on performance of the enterprise as systematic risks.

Basel committee on banking and supervision (2008) published principles of sound liquidity risk
management and supervision where fundamental principles for the management and supervision
of liquidity risk were highlighted. Thus banks should have risk management framework that
ensures availability of liquidity assets sufficient to survive stress environment (Kim, 2015).

The multiple regressions show there is a significant impact of all business and financial risk
variables on performance at significant level 10%. (Alshubiri, 2015)

(Wanjohi, et al, 2017) found out that majority of the Kenyan banks were practicing good
financial risk management and as a result the financial risk management practices mentioned
herein have a positive correlation to the financial performance of commercial banks in Kenya.

(Musiega M, Olweny T, 2017) examine the influence of liquidity risk on performance of

commercial Banks .he used Panel data for 30 commercial banks that had data for 10 year period
from 2006 to 2015 His findings were liquidity risk measured by Liquid assets to total assets ratio
had a positive and significant relationship with performance.

(Md. Mohiuddin, Shafir Zaman, 2018) analyze the effect of Liquidity risk on the Islamic banks
performance for the period 2012 to 2016. In Bangladesh Correlation, Regression analysis are
done to find the effect of liquidity on bank performance. The correlation found significant
relationship between Bank performance and liquidity indicators. On the other hand regression
analysis showed that there is negative relation between bank performance and liquidity
indicators.

(Waswa, Mukras and Oima, 2018) investigate the effect of liquidity management on firm
performance using a sample of five sugar firms over the period 30th June 2005 to 2016. He
estimate a random effects regression model where the results suggest that a negative relationship
exists between liquidity management on firm performance.

1.3. Problem Statement:

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Sensitivity analysis

A sensitivity analysis determines how different values of an independent variable affect a

particular dependent variable under a given set of assumptions. This technique is used within
specific boundaries that depend on one or more input variables, such as the effect that changes in
interest rates (independent variable) has on bond prices (dependent variable).

It is also known as the what – if analysis. Sensitivity analysis can be used for any activity or
system. All from planning a family vacation with the variables in mind to the decisions at
corporate levels can be done through sensitivity analysis.
It helps in analyzing how sensitive the output is, by the changes in one input while keeping the
other inputs constant.
Sensitivity analysis works on the simple principle: Change the model and observe the
behavior.
The parameters that one needs to note while doing the above are:
A) Experimental design: It includes combination of parameters that are to be varied. This
includes a check on which and how many parameters need to vary at a given point in time,
assigning values (maximum and minimum levels) before the experiment, study the correlations:
positive or negative and accordingly assign values for the combination.
B) What to vary: The different parameters that can be chosen to vary in the model could be: 
a) the number of activities
b) The objective in relation to the risk assumed and the profits expected
c) technical parameters
d) number of constraints and its limits
C) What to observe:
a) the value of the objective as per the strategy
b) value of the decision variables
c) value of the objective function between two strategies adopted

Methods of Sensitivity Analysis

There are different methods to carry out the sensitivity analysis:

 Modeling and simulation techniques

 Scenario management tools through Microsoft excel

There are mainly two approaches to analyzing sensitivity:

 Local Sensitivity Analysis

 Global Sensitivity Analysis

Local sensitivity analysis is derivative based (numerical or analytical). The term local indicates
that the derivatives are taken at a single point. This method is apt for simple cost functions, but
not feasible for complex models, like models with discontinuities do not always have derivatives.
Mathematically, the sensitivity of the cost function with respect to certain parameters is equal to
the partial derivative of the cost function with respect to those parameters.
Local sensitivity analysis is a one-at-a-time (OAT) technique that analyzes the impact of one
parameter on the cost function at a time, keeping the other parameters fixed.
Global sensitivity analysis is the second approach to sensitivity analysis, often implemented
using Monte Carlo techniques. This approach uses a global set of samples to explore the design
space.
The various techniques widely applied include:

 Differential sensitivity analysis: It is also referred to the direct method. It involves

solving simple partial derivatives to temporal sensitivity analysis. Although this method
is computationally efficient, solving equations is intensive task to handle.
 One at a time sensitivity measures: It is the most fundamental method with partial
differentiation, in which varying parameters values are taken one at a time. It is also
called as local analysis as it is an indicator only for the addressed point estimates and not
the entire distribution.
  Factorial Analysis: It involves the selection of given number of samples for a specific
parameter and then running the model for the combinations. The outcome is then used to
carry out parameter sensitivity.

Through the sensitivity index one can calculate the output % difference when one input
parameter varies from minimum to maximum value.

 Correlation analysis helps in defining the relation between independent and dependent

variables.
 Regression analysis is a comprehensive method used to get responses for complex
models.
 Subjective sensitivity analysis: In this method the individual parameters are analyzed.
This is a subjective method, simple, qualitative and an easy method to rule out input
parameters.

Using Sensitivity Analysis for decision making

One of the key applications of Sensitivity analysis is in the utilization of models by managers
and decision-makers. All the content needed for the decision model can be fully utilized only
through the repeated application of sensitivity analysis. It helps decision analysts to understand
the uncertainties, pros and cons with the limitations and scope of a decision model.
Most if not all decisions are made under uncertainty. It is the optimal solution in decision making
for various parameters that are approximations. One approach to come to conclusion is by
replacing all the uncertain parameters with expected values and then carry out sensitivity
analysis. It would be a breather for a decision maker if he / she has some indication as to how
sensitive will the choices be with changes in one or more inputs.

Uses of Sensitivity Analysis

 The key application of sensitivity analysis is to indicate the sensitivity of simulation to

uncertainties in the input values of the model.
 They help in decision making
 Sensitivity analysis is a method for predicting the outcome of a decision if a situation
turns out to be different compared to the key predictions.
 It helps in assessing the riskiness of a strategy.
 Helps in identifying how dependent the output is on a particular input value. Analyses if
the dependency in turn helps in assessing the risk associated.
 Helps in taking informed and appropriate decisions
 Aids searching for errors in the model
Sectorial analysis

DEFINITION of Sector Analysis

Sector analysis is an assessment of the economic and financial condition and prospects of a given
sector of the economy. Sector analysis serves to provide an investor with a judgment about how
well companies in the sector are expected to perform.

Sector analysis is typically employed by investors who specialize in a particular sector, or who
use a top-down or sector rotation approach to investing. In the top-down approach, the most
promising sectors are identified first, and then the investor reviews stocks within that sector to
determine which ones will ultimately be purchased. A sector rotation strategy may be employed
by investing in particular stocks or by employing sector-based exchange-traded funds.

BREAKING DOWN Sector Analysis

Sector analysis is based on the premise that certain sectors perform better during different stages
of the business cycle. Early in the business cycle, for example, interest rates are low and growth
is beginning to pick up. During this stage, companies that benefit from low interest rates and
increased borrowing often do well. These include companies in the Financial and Consumer
Discretionary sectors. Late in an economic cycle, when growth is slowing, defensive sectors such
as Utilities and Telecommunication Services often outperform.

In sector rotation strategies, investors may define sectors in a variety of ways. But a commonly
used taxonomy is the Global Industry Classification Standard (GICS)developed by MSCI and
Standard & Poor's. GICS consists of 11 sectors, which are broken down into 24 industry groups,
68 industries and 157 sub-industries. The Consumer Staples sector, for example, consists of three
industry groups: 1) Food & Staples Retailing, 2) Food, Beverage & Tobacco, and 3) Household
& Personal Products.

These industry groups are broken down further into industries. Food, Beverage & Tobacco, for
example, consists of those three, which are then broken into sub-industries. The Beverage
industry, for example, is made up of three sub-industries: Brewers, Distillers & Vintners, and
Soft Drinks.

Sector rotators and others who employ a top-down approach don't necessarily limit themselves to sectors.
They may choose to emphasize industry groups, industries, or sub-industries.
1.4. Research question:

 At what level business risk affect firm’s performance.

 How financial risk affect firm’s performance.
 How liquidity risk affect firm’s performance.

1.5. Research Objectives:

The main objective of this study was to analyze effects of risks to firm’s performance in
Pakistan. Relating to above main objective some other objectives are

1. To find out how business risk affect firm’s performance.

2. To find out how financial risk affect firm’s performance.
3. To find out how liquidity risk affect firm’s performance.

1.6. Significance of study:

There are large work on liquidity risk in banking sector in Pakistan (Shafiq A. and Nasr M. 2010
Akhtar 2011, Ahmed et al. 2012, Arif and Anees 2012, Wambu 2013, Umar, Muhammad, Asad
and Mazhar 2015) worked on liquidity risk in bank in Pakistan.

In line with Shafiq A. and Nasr M. (2010) Risk Management Practices Followed By the
Commercial Banks in Pakistan. But there is no work on impact of risk on firm performance of
non-financial firms in Pakistan.

Despite this, Vakilifard H. and Malektaj M. (2014) investigated the impact of risk on firm
performance of Iranian automobile industry firms. His research limited to one automobile
industry sector, he suggested that future research should investigate generalization of the
findings among other industries and other countries it is suggested that firms should use other
risk factors to predict firm performance.

This study is unique in nature. It will contribute additional knowledge in management of

business. It will be helpful for managers, owners and investors in non-financial sectors because
there is large studies on financial sectors like banking sectors but no one in non- financial
sectors.
This research findings will help in addressing the existing knowledge gap in literature of overall
risk affecting financial performance of non- financial firms in Pakistan.

In line with above discussion it is stated that there is no evidence of sensitivity and sectorial
analysis to examine the impact of risk on firm performance in different economic recessions.
2. Literature review:

Significant literature is present regarding financial constraints and investments. Modigliani and
Miller (1958) stated that there exist perfect capital markets and external funds are perfect
substitute of internal finance thus they stated that firms’ financial decisions are irrelevant in
determining their investment behavior10. However, Fazzari et al. (1988), Whited (1992), Bond
and Meghir (1994) and Kaplan and Zingales (1997) investigated investment behavior for
empirical evidence of financial constraints and developed the equilibrium model by
incorporating market frictions in business cycle fluctuations. Their studies clearly support that
frictions are present in capital market signifying that internal and external capital are not perfect
substitutes. In review of Pakistan’s case, financial market is not perfect which leads to finance
becoming the foremost obstacle in firms’ investment level (Ahmad and Naveed 2011). This
realism clearly supports the phenomenon presented by previous studies. Hence Firms mostly
prefer to employ internal financing initially for investment activities.

There exists financial hierarchy which states that internally arranged funds are cheaper than
external financing11, Bond and Meghir (1994). Their study examined the sensitivity of
investment to availability of internally generated funds using hierarchy of finance model. Results
indicated that firms’ current investment level depends upon their investments in previous years
and lagged cash flows. Standard neoclassical Euler model is valid in describing investment
behavior of unrestricted firms but do not supports the case of restricted firms. Results implied
that lagged investment, sales and low debt ratio have positive effect on investments. Bishop et al.
(2004) adopted the methodology of Bond and Meghir (1994). There results recommend that lack
of foreign ownership lead firms to be dependent on internal funds hence small firms are
financially constrained by having limited access to external funds. On the other hand, foreign
ownership firms face ease in investment activities for their growth for the reason that these firms
have more access to external finance. The relationship between firms’ investments and their
financial status has been explored by Johansen (1994) who advocated that increase in debt ratio
is responsible for costly external financing. They adopted Bond and Meghir (1994) methodology
and found that there holds positive relation between firm’s debt ratio and its capital return. This
indicates that firms with higher debt ratio bear costly external financing therefore these firms rely
mainly on internal funds for their investment activities and thus become financially constrained.
In recent work, Ruano (2006) applied Bond and Meghir (1994) methodology and used the split
sample approach by distributing firms in deciles by their lagged cash flow to current investment
ratio on the basis of assumption that probability of financial constraints decreases with the
augment in this ratio. Findings indicate that firms in upper deciles are unrestricted as their cash
flow to investment ratio is positive whereas firms in initial deciles imply that their investment
dynamics are determined with the availability of internal funds and hence these firms are
financially restricted. These results supported Bond and Meghir (1994) which is valid for
describing investment behavior of firms in absence of financial constraints.

Market friction problems not only lead to disturb the ability of firms to obtain external funds but
also their investment behavior. The said argument has been clearly supported by Whited (1992)
in his study. The standard Euler investment model is altered by inclusion of binding debt
constraint effect which improved Euler equation model by taking in to account investment and
capital stock of firms. Findings imply that firm’s investment can be undoubtedly assessed with
its ability to access for external financing.

To explore the literature on financial constraints and their influence on investment behavior of
enterprises, Kirshecsh (2004) established a connection between investment decisions and firms’
financial risk in his study. They included bankruptcy risks in neoclassical model of investment
by altering profit maximizing computation on the basis that future expected revenues will be
weighted with firms’ probability of survival. Findings confirm that survival probability measured
from bankruptcy prediction model is genuine in linking between firm’s investment and its
financial risk. Findings suggest that higher debt to capital ratio indicates that the firms face
obstacles in capital markets regarding external financing and hence become financially
constrained.

To explore whether the financial constraints are present in Malaysian market affecting firms’
behavior findings of Ismail et al. (2010) rejected the neoclassical investment theory which
assumed perfect capital market where only factor prices and technology determine the capital
stock of firms by implying that financial constraints are present in Malaysian markets which
hinder firms from accessing external financing. Results confirmed that investment activities of
firms are greatly affected by their cash flows or retained earnings.
By reviewing in context to Pakistan’s case, the impact of internal and external constraints has
been studied by Azam and Shah (2011) to assess their influence on investment choice of
Pakistani firms. Empirical analysis showed that there exists positive relationship among firm’s
size and its investment whereas an inverse relationship holds among firm’s age and its
investment. Besides these results they found that dividend payout behavior of firms has negative
effect on investment too. This shows that if a firm grows old or pay high dividends consequently
it will reduce its investment level.

Similarly, financial constraints are present in Brazilian firms as evidenced by the study of
Crisóstomo et al. (2012). Firm size explored to be having influencing effect on investments of
Brazilian firms. Lima Crisóstomo et al. (2012) observed that small sized firms are more
responsive towards progression of internal funds and hence are constrained by internal finance as
compared to unconstrained firms. Similar are the results of Abid Ismail et al. (2010) for
Malaysian firms. Their study stated that presence of financial constraints in Malaysian capital
markets creates hurdles for firms in attaining external finance thus internal finance is of
considerable importance for these firm. Their results showed that large sized firms are not
financially constrained while severity of constraints is present in case of small sized firms.

In literature, the lag of investment to capital ratio is found to be positively effecting current
investment to capital ratio as confirmed by the studies of Kirchesch (2004), Ismail et al. (2010),
Bond and Meghir (1994) and Ruano (2006). While it is found negative in studies of Terra
(2002), La Cava (2005), Guariglia (2008) and Butzen et al. (2001).

Bulk of empirical studies exists highlighting the existence of financial constraints that potentially
limit the capability of firms to grow overtime by becoming barrier in their investment behavior.
The initiative empirical study in context to financial constraints was done by Fazzari, Hubbard
and Peterson (1988) to observe whether financial constraints justify the sensitivity of investment
to cash flows. Empirical results indicated that external funds are not perfect substitutes of
internal financing and there exists hierarchy of finance in which firms have cost advantage of
internal financing over external financing. Investments of constrained firms are more sensitive
towards cash flows as compared to unconstrained firms hence, these firms have to rely more on
internally generated firms. Consequently, investment cash flow sensitivity of firms increases
with the level of financial constraints.
Similar argument is presented by Chapman et al. (1996) by studying role of cash flow as a
determining factor of investment in fixed assets at firm level for Australian firms. Their results
pointed out firms reveal larger cash flow sensitivity when are financially constrained and lower
sensitivity when are unconstrained. Moreover, sales also have valuable role in case of
unconstrained firms.

Contrary to the argument presented above, the investment cash flows sensitivity among firms
does not monotonically increases with the increase in financial constraints according to the study
of Kaplan and Zingales (1997) which supported that the investment cash flow sensitivities do not
indicate support for presence of financing constraints. They studied the importance of financial
constraints in determining firm’s investments and applied the Euler equation approach developed
by Bond and Meghir (1994) based on regressing current investment on preceding investment and
its square, sales, cash flows, debt square. Their findings conflict with those of FHP (1988) by
proposing that least financially constrained firms reveal greater investment cash flow sensitivity
than those of unconstrained firms and there exists positive correlation among degree of financial
constraints and investment cash flow sensitivities.

Similar work to observe firm’s financial status and its impact on their investment behavior has
been done by Cleary (1999) by distributing firms in different groups’ accordingly financial
variables. Firms’ financial status is measured through multiple discriminant analysis for
predicting bankruptcy which allows reclassification of firms’ accordingly different periods
reflecting that firms’ financial constraint level changes overtime. The empirical results are
perfectly consistent with the opinion of KZ (1997) signifying that investment decisions of firms
with high creditworthiness according to prevailing financial measures are particularly sensitive
towards internal funds availability to as that of the firms with low creditworthiness. Observed
results clearly state that internal finance is the leading source of financing for firms and firms
increase their investments with the availability of cash flows.

The findings that investment cash flow sensitivities do not hold in the case of financing
constraints of the study of KZ (1997) were criticized by Fazzari et al. (2000) who suggest that
there is monotonicity in investment cash flow sensitivity with respect to financing constraints.
Their results contradict on two bases i.e. there may me lack of heterogeneity in the sample
secondly, they claim that the firms taken in KZ (1997) are financially distressed instead of
financially constrained and unconstrained firms are in fact constrained. Fazzari et al. (2000) also
criticized Cleary (1999) on the same grounds that found relatively low sensitivity for partially
constrained firms but not distressed firms. They still undoubtedly argue that investment
sensitivities increase with the degree of financial constraints.

In respond to the criticism of FHP (2000) valid explanation has been presented by Kaplan and
Zingales (2000) provided theoretical and empirical evidence that differential sensitivity is not a
suitable measure of financing constraints. In their argument there is no such monotonicity in the
relationship between degree of financing constraints and investment sensitivities.

Firms’ Asset tangibility positively impacts the investment-Cash flow sensitivity as far as
financially constrained firms are concerned. Almieda and Campello (2007) provided such
evidence in their study by analyzing constrained and unconstrained firms accordingly their
higher or lower asset tangibility. They observed that sensitivity of investment towards cash flows
increases with firms’ assets tangibility but this result is absent in case of firms’ with higher assets
tangibility.

Investment cash flow sensitivity is found to be having positive effect on group and ungrouped
firms. George et al. (2010) observed the data set of business group firms and found that
investment cash flow sensitivity is relatively more in grouped firms than that of the ungrouped
firms.

Arif and Anees (2012) undertook a research on liquidity risk and its effects on banks profitability
in Pakistan. The research found that there existed significant negative relationship between
liquidity, deferred loans, liquidity gap and profitability. In a similar research done by Ahmed
and Ahmed (2012) where 22 banks in Pakistan were used for the period 2004 to 2009. The
findings were that profitability was positively correlated with liquidity gap similarly Chen, Shen
and Kao (2010) studied the pattern of liquidity risk of bank on performance for commercial
banks in 12 advanced economic countries for the years 1994-2006 and found that liquidity risk is
a determinant of bank performance. Alper and Anbar (2011) examined special and
macroeconomic determinants of Turkey's bank for the years 2002-2010 using panel data and
found that liquidity had positive effects on the bank's performance. This is consistent to Naser,
Mohammad and Ma'someh, (2013) based on 15 banks of Iran during the years 2003-2010
liquidity risk had a significantly negative effect on performance. There is a statistically
significant in explaining the model of CAPM and market risk spreads (Amiri et al., 2010). Chen
(2011) found there is a negative relationship between the market value of capital and stock
returns as a result of changes in risk factors, which may reflect on the performance of banks.

Arif and Anees (2012) undertook a research on liquidity risk and its effects on banks profitability
in Pakistan. The research found that there existed significant negative relationship between
liquidity, deferred loans, liquidity gap and profitability. Financial risks have a great impact on
firm’s performance. Jamal A. Noor and Abdalla (2014)

Kiseľáková D., Horváthová J. (2015) .The aim of this article is the analysis of impact of selected
systematic and unsystematic risks to performance of the enterprises. He used secondary data of
financial statements the selected company, which is representative of the Slovak food industry.
He conclude that the most significant impact on performance of the enterprise has just financial
risk. According to our calculations, it was confirmed that the unsystematic risks have a higher
impact on performance of the enterprise as systematic risks.

Basel committee on banking and supervision (2008) published principles of sound liquidity risk
management and supervision where fundamental principles for the management and supervision
of liquidity risk were highlighted. Thus banks should have risk management framework that
ensures availability of liquidity assets sufficient to survive stress environment (Kim, 2015).

The multiple regressions show there is a significant impact of all business and financial risk
variables on performance at significant level 10%. Alshubiri, (2015)

Wanjohi, et al (2017) found out that majority of the Kenyan banks were practicing good financial
risk management and as a result the financial risk management practices mentioned herein have a
positive correlation to the financial performance of commercial banks in Kenya.

Musiega M, Olweny T, (2017) examine the influence of liquidity risk on performance of

commercial Banks .he used Panel data for 30 commercial banks that had data for 10 year period
from 2006 to 2015 His findings were liquidity risk measured by Liquid assets to total assets ratio
had a positive and significant relationship with performance.

Md. Mohiuddin, Shafir Zaman (2018) analyze the effect of Liquidity risk on the Islamic banks
performance for the period 2012 to 2016. In Bangladesh Correlation, Regression analysis are
done to find the effect of liquidity on bank performance. The correlation found significant
relationship between Bank performance and liquidity indicators. On the other hand regression
analysis showed that there is negative relation between bank performance and liquidity
indicators.

Waswa, Mukras and Oima(2018) investigate the effect of liquidity management on firm
performance using a sample of five sugar firms over the period 30th June 2005 to 2016. He
estimate a random effects regression model where the results suggest that a negative relationship
exists between liquidity management on firm performance.

2.1. Theories:

Modern portfolio theory (MPT) is a theory of finance that attempts to maximize portfolio
expected return for a given amount of portfolio risk, or equivalently minimize risk for a given
level of expected return, by carefully choosing the proportions of various assets.

The stakeholder theory was originally detailed by Edward Freeman (1984). Stakeholder theory
focuses explicitly on equilibrium of stakeholder interests as the main determinant of corporate
policy. The most promising contribution to risk management is the extension of implicit
contracts theory (a part of stakeholder theory) from employment to other contracts, including
sales and financing (Cornell & Shapiro, 1987). Klimszk (2008) argued that in certain industries,
particularly high-tech and services, consumers’ trust in a company can substantially contribute to
the company’s value also the value of implicit claims is highly sensitive to expected costs of
financial distress and bankruptcy. Since corporate risk management practices lead to a decrease
in these expected costs, company value rises (Klimczak, 2005). The more sensitive a company’s
value is to financial distress, the higher the motivation for hedging hence reducing financial risk

2.3 Variables:

2.3.1 Dependent Variables;

Performance measurement is a very important aspect of every business activities. Firm

performance has been the most important issue for every organization. It is very important for
managers to know which factors influence firm’s performance in order to take appropriate steps
to initiate that factors. (Abu-Jarad, I.Y., N. Yousof and D. Nikbin, 2010). (Ofley 2003) stressed
the importance of performance as financial measure as a tool of financial management, main
goal of an organization, and a means of motivating and controlling activities within an
organization. In this study I will use the dependent variable firm performance (PER) and it will
be measure by net profit ratio (NPR) because Profit is the ultimate goal of all firms. All the
strategies designed and activities performed thereof are meant to realize this grand objective. It
calculated by net profit or loss divided by net sales revenue for every firm from 50 firms in ten
non-financial sectors in Pakistan.

2.3.2 Independent Variables:

Business risk;

The business risk used two measures first Earnings variability calculate by the standard deviation
earnings-to-price ratio. And second is Earnings growth (EG) calculated by the current year of net
profit minus previous year of net profit divided previous year of net profit.

The multiple regressions show there is a significant impact of all business risk variables on firm
performance. Alshubiri, (2015)

Financial risk;

The financial risk used also two measures as the following first Financial leverage calculate by
dividing of total debt to total asset second is Current ratio calculates by dividing total current
assets to current liabilities. Financial risk can be evaluated through different indicators like
Debt/Equity, EBIT (Earnings before interests and taxes) / interest expense, loan repayments from
Cash Flow, share of net working capital on current assets, current ratio and quick ratio, Average
Collection Period, average period of inventories. The methods of analyzing and quantifying of
the risk are well known statistical tools and techniques to express numerical level of risk (Fotr
and Soucek, 2011).

Financial risks have a great impact on firm’s performance. Jamal A. Noor and (Abdalla 2014)

The multiple regressions show there is a significant impact of all financial risk variables on firm
performance. (Alshubiri, 2015).

Liquidity risk;
According to George et al, (2013) a significant, negative correlation existed between liquidity
risk and firms profitability. Waswa, Mukras and Oima (2018) investigate the effect of liquidity
management on firm performance using a sample of five sugar firms over the period 30th June
2005 to 2016. He estimate a random effects regression model where the results suggest that a
negative relationship exists between liquidity management on firm performance.

(Total Capital/ Total Assets)

Sector level

Munificence

Munificence is refers to an environmental ability to provision of continuous organizational

growth (Aldrich, 1979). Firm commit more illegal acts, who are in less munificent environments.
(Staw & Swajkowski 1975) In other words, when industries exist in munificent environment
then, firms are to be expected more responsible to participate in socially responsible behavior.

According to Beard and Dess (1984), the capacity of an environment to maintain a persistent
growth is called munificence. The sectors/industries operating in ordinary environment with high
munificence tend to have greater level of opportunities as compared to industries with low
munificence (Almazan and Molina, 2005). In relation to that, Almazan and Molina (2005) found
greater variations in the capital structure of firms, working in the sectors/industries which have
greater growth opportunities. These sectors/industries therefore, enjoy greater profitability due to
less competitive environment. Hereby, consistent with these arguments, the firms generate more
profits; those operate in sectors with high level of munificence it infers a positive relationship
between munificence and the leverage, which substantiates the pecking order hypothesis.
Whereas, the opposite relationship between munificence and the leverage confirms the agency
cost theory. More recently, Smith et al. (2014) reported that firms operating in highly munificent
environment with above-target debt, which have more abundant resources, tend to reduce
leverage and rapidly adjust towards their target debt.
Consistent with agency cost theory, Kayo and Kimura (2011) found inverse relation between
leverage and munificence, which simply confirmed the pertinence of agency cost theory. As
compared to developing countries, the business environment in developed markets is more
competitive; hence, the munificence tends to be insignificant in developed countries. Since the
nature of every sector is different in developing countries and every sector is subject to different
level of competitiveness, therefore, the study predicts different relationship between munificence
and leverage across sectors in developing countries.

According to Khan, M.A.H., Hussain, M. and Ilyas, (2017), Munificence indicate negative but
significant relation with investment.

Dynamism

Dynamism serves as a market mechanism in which entrepreneurs efficiently reallocate capital

and labor resources from less to more productive uses (Decker et al., 2014; Hathaway and Litan,
2014).
Generally, dynamism measures the extent to which an environment is stable or unstable (Smith
2014). By definition, more dynamic environments are less stable. Firms operating in a dynamic
environment tend to deal with more uncertainty regarding growth (Boyd, 1995). The
environmental dynamism describes the rate and instability of changes in a firm’s external
environment (Dess and Beard, 1984; Simerly and Li, 2000). According to Jiao, Alon and Cui
(2011), across industries there are significant differences in terms of the impacts of
environmental characteristics on firms. In this regard, Simerly and Li (2000), observed a positive
association between leverage and firm’s performance which operate under stable environment. In
contrast, leverage negatively related with the firm’s performance that operate under dynamic
environment. In the purview of dynamism, Simerly and Li (2000) further argued that across
industries the environmental dynamism is different; therefore, it differently affects the similar
activities across industries or sectors. According to Kayo and Kimura (2011), firms tend to have
similar properties that operate within a particular sector or industry; hence, they expect to have
similar environment. The firms operating in similar sector /industry are exposed to systematic
risk (business risk), when the environment under which they operating becomes unstable. In this
notion, it can be documented that high dynamism creates more uncertainty; therefore, it reduces
the level of leverage.
Consequently, the firms operating under dynamic environment may tend to use equity financing
to lessen the transaction cost occurring from increased level of risk. On the other hand, firms
operating under the environment with lower dynamism tend to use more debt financing. In a
study across emerging markets, Kayo and Kimura (2011) found a positive but insignificant
relationship between leverage and environmental dynamics. Suffice to say, the business
environment in developed and emerging economies is more stable and less dynamic as compared
to developing economies. Furthermore, the sectors in developing countries have different
attributes with respect to systematic and unsystematic risks and internal and external economic
shocks; therefore the study expects different relationships between leverage and dynamism
across sectors in developing countries.
Herfindahl-Hirschman Index (HHI)
The Herfindahl-Hirschman Index (HHI) is a common measure of market concentration and is
used to determine market competitiveness, often pre- and post-M&A transactions.
The Herfindahl-Hirschman Index (HHI) is a commonly accepted measure of market
concentration. It is calculated by squaring the market share of each firm competing in a market
and then summing the resulting numbers. It can range from close to zero to ten thousand. The
U.S. Department of Justice uses the HHI for evaluating potential mergers issue

Where:

 sn is the market share percentage of firm n expressed as a whole number, not a decimal.

How Does the Herfindahl-Hirschman Index Work?

The closer a market is to a monopoly, the higher the market's concentration (and the lower its
competition). If, for example, there were only one firm in an industry, that firm would have
100% market share, and the Herfindahl-Hirschman Index (HHI) would equal 10,000, indicating
a monopoly. If there were thousands of firms competing, each would have nearly 0% market
share, and the HHI would be close to zero, indicating nearly perfect competition.

The U.S. Department of Justice considers a market with an HHI of less than 1,500 to be a
competitive marketplace, an HHI of 1,500 to 2,500 to be a moderately concentrated marketplace,
and an HHI of 2,500 or greater to be a highly concentrated marketplace. As a general rule,
mergers that increase the HHI by more than 200 points in highly concentrated markets raise
antitrust concerns, as they are assumed to enhance market power under the section 5.3 of the
Horizontal Merger Guidelines jointly issued by the department and the FEDERAL TRADE
COMMISSION (FTC).

The primary advantage of the Herfindahl-Hirschman Index (HHI) is the simplicity of the

calculation necessary to determine it and the small amount of data required for the calculation.
The primary disadvantage of the HHI stems from the fact that it is such a simple measure that it
fails to take into account the complexities of various markets in a way that allows for a genuinely
accurate assessment of competitive or monopolistic market conditions.

Limitations of the HHI Index

The basic simplicity of the HHI carries some inherent disadvantages, primarily in terms of
failing to define the specific market that is being examined in a proper, realistic manner. For
example, consider a situation in which the HHI is used to evaluate an industry determined to
have 10 active companies, and each company has about a 10% market share. Using the basic
HHI calculation, the industry would appear highly competitive.

However, within the marketplace, one company might have as much as 80% to 90% of the
business for a specific segment of the market, such as the sale of one specific item. That firm
would thus have nearly a total monopoly for the production and sale of that product.

Another problem in defining a market and considering market share can arise from geographic
factors. This problem can occur when there are companies within an industry that have roughly
equal market share, but they each operate only in specific areas of the country, so that each firm,
in effect, has a monopoly within the specific marketplace in which it does business. For these
reasons, for the HHI to be properly used, other factors must be taken into consideration and
markets must be very clearly defined.

Model:

PERit = α0 + β1 BRit + β2FRit + β3LRit+ εit

 Business
Risk

Financial
HHI Risk

Firm
Performance

Dynamism
Liquidity
Risk

Munificence

Hypothesis of the study:

1. Financial risk has significant impact on firm performance.
2. Business risk has significant impact on firm performance.
3. Significant, negative correlation existed between liquidity risk and firms performance.
4. Munificence indicate negative but significant relation with investment.
5. Dynamism risk has significant impact on firm’s performance.
6. HHI risk has significant impact on performance of the firm.
3. Research methodology
Data collection:
The secondary data of the financial statement of companies listed in PSE will be used. Statistical
population of the present study is all non-financial companies listed in Pakistan stock exchange.
Fifty companies will be chosen as sample from 5 different sectors THE FIRMS FROM EACH
SECTOR SELECTED ON TH BASE OF HIGHLY CAPITALIZATION??
Five from each sector. Different sources will be used, like state bank of Pakistan, Website of
Pakistan Stock Exchange and websites of the Companies.
SOURCES OF DATA
NBP, IMF, WORLD BANK ANNUAL REPORTS FSA BSA OF ALL SECTORS FIRMS

TOOLS OF ANALYSIS;

Descriptive Summary;

The descriptive summary shows the health of instruments. It include the mean, median,
minimum and maximum values. The standard deviation that shows the risk in various factors.
However this diagnostic test can be used for kurtosis and skewness.

According to Weiers (2010) descriptive summary is used to make an overall glance of large data
set.

Correlation Matrix

Correlation

The test of correlation shows the results for the issue of multicolentry. The issue of multicolentry
exist when two or more variables shows same phenomena or give same results more than 70%. If
this issue exist in data then one variable from model would be excluded. Analysis has been
conducted to see correlation among variables.Gill (2011), Wasiuzzaman S. (2013), Abraham
Ansong (2013), Adekunle A. & kajola (2015), Azami. Z and Jeyhoon. F. (2016)

OLS
A German mathematician of the 18th century Carl Friedrich Gauss invented the OLS, a
technique for assessing parameters (Deakin, 2015). In statistics, ordinary least squares (OLS) is
a method for estimating the unknown parameters in a linear regression model. OLS chooses the
parameters of a linear function of a set of explanatory variables by the principle of least
squares.The use of pooled OLS is anchored on the assumption that there are no group or
individual effects among the firms. However, as panel contains observation on the same
crosssectional units over several time periods, there are most likely to be cross-sectional effects
on each firm or on a set of group of firms.

According to Denham (2010) in studying the relationships between the independent and
dependent variables most commonly used models is OLS regression models. These researcher
recently used this model.

Hausman Test

Apparently, it is required to take care of the nature of the unobserved individual effect to
examine the fixed or random effects model which is more suitable and significant for the study
framework (Ahn & Low, 1996). As a result, the model specified test in econometrics proposed
by Hausman (1978) which is widely used by many researchers to figure out both the theoretical
and statistical basis in selecting between the fixed and random effects model is the Hausman test.
The Hausman test was used by the majority of economic researchers as a standard rule to choose
between fixed effects and random effects (Baltagi et al., 2003; Hsiao, 2007).

Fixed Model

This estimation method tried to examine the exact contrast in the intercept (Greene,

Han, & Schmidt, 2002). The examination of the exact contrast in the intercepts is carried out by
allowing each individual to have its own cut off value. Whilst the intercept value may differ
across entities, the term “fixed effect” shows that the slope coefficients are not different across
individuals. Besides, the individual specific effect is constant over period which means that the
time invariant and there is a connection between the error component and other regresses (Wang
& Ho, 2010).
 Fixed effect approach takes into consideration the individuality of each firm or cross-sectional
unit included in the sample by allowing the intercept to vary for each firm while assuming that
the slope coefficients are constant across firms.

Table 1:
Variables Measurement Evidence
Firm performance net profit or loss divided by net sales
Business Risk Earnings growth
(Current year of net profit - previous
year of net profit / previous year of net
profit.
Financial risk
Debt to equity
Ratio
Interest Coverage
Liquidity risk
Current Ratio
Liquid Ratio
Munificence
Dynamism
HHI

Econometric equation

The Econometric Methods make use of statistical tools and economic theories in combination to

estimate the economic variables and to forecast the intended variables. The econometric model
can either be a single-equation regression model or may consist a system of simultaneous
equations. In most commodities, the single-equation regression model serves the purpose.

But, however, in the case where the explanatory economic variables are so interdependent or
interrelated to each other that unless one is defined the other variable cannot be determined, a
single-equation regression model does not serve the purpose. And, therefore in such situation, the
system of simultaneous equations is used to forecast the variable.

The econometric methods are comprised of two basic methods, these are:

1. Regression Method: The regression analysis is the most common method used to

forecast the demand for a product. This method combines the economic theory with statistical
tools of estimation. The economic theory is applied to specify the demand determinants and the
nature of the relationship between under the regression method, the first and the foremost thing is
 to determine the demand function. While specifying the demand functions for several
commodities, one may come across many commodities whose demand depends by or large, on a
single independent variable. For example, suppose in a city, the demand for items like tea and
coffee is found to depend largely on the population of the city, then the demand functions of
these items are said to be single-variable demand functions.

On the other hand, if it is found out that the demand for commodities like sweets, ice-creams,
fruits, vegetables, etc., depends on a number of variables like commodity’s own price, the price
of substitute goods, household incomes, population, etc. Then such demand functions are called
as multi-variable demand functions.

Thus, for a single variable demand function, the simple regression equation is used while for
multiple variable functions, a multi-variable equation is used for estimating the demand for a
product.

2. Simultaneous Equations Model: Under simultaneous equation model, demand

forecasting involves the estimation of several simultaneous equations. These equations are often
the behavioral equations, market-clearing equations, and mathematical identities.

The regression technique is based on the assumption of one-way causation, which means
independent variables cause variations in the dependent variables, and not vice-versa. In simple
terms, the independent variable is in no way affected by the dependent variable. For example, D
= a – bP, which shows that price affects demand, but demand does not affect the price, which is
an unrealistic assumption.

On the contrary, the simultaneous equations model enables a forecaster to study the simultaneous
interaction between the dependent and independent variables. Thus, simultaneous equation
model is a systematic and complete approach to forecasting. This method employs several
mathematical and statistical tools of estimation.

The econometric methods are most widely used in forecasting the demand for a product, for a
group of products and the economy as a whole. The forecast made through these methods is
more reliable than the other forecasting methods.
Refrences

https://www.investopedia.com/terms/s/sector-analysis.asp

https://www.investopedia.com/terms/s/sensitivityanalysis.asp