The Role of Corporate Governance and Financial Condition on Stock Returns in Indonesia

Abstract

This research aims to examine and assess how management methods, financial conditions, and corporate governance strategies affect stock returns. This study employs a quantitative approach with a population of 1968 firms with stock returns (return) and a sample of 225 companies with corporate governance practices in the manufacturing industry in Indonesia from 2013 to 2018. The findings of this study show that strategic management has a significant impact on stock return, financial condition, and corporate governance strategy. The findings of this study on debt strategy as a proxy for management strategy, debt default as a proxy for economic conditions, corporate governance strategy as a proxy for centralized ownership, and independent commissioners function as a mechanism of internal and external control in increasing stock return for investors all support increasing stock return for investors. The cost reduction strategy includes reducing operating costs unless the audit committee has not yet functioned as an internal control or requirement for a company to be listed with the Financial Services Authority on the Indonesia Stock Exchange.

1. Introduction

The urgency of this research was motivated by the high level of uncertainty in the future as a result of the deteriorating economic conditions caused by the COVID-19 pandemic, which increased the weight of auditors’ and auditees’ duties. Because of the worsening economic conditions caused by the COVID 19 pandemic, the company’s sustainability is being assessed based on its ability to continue operations within the next 12 months, which means the assessment is based on the availability of cash funds to carry out its business activities. Problems arise when there are many audit failures made by auditors regarding the company’s sustainability opinion (Mayangsari, 2003). The study indicates that an increase in the overall number of verified illnesses and deaths due to COVID-19 has a significant negative influence on Indonesia’s daily stock returns. Furthermore, regardless of how stringent the lockout restrictions are, they have a positive and significant impact on Indonesia’s daily stock returns. The impact of the COVID-19 pandemic on each of the eight observed sectors is also considered, with the property sector, as well as trade, service, and investment, having a significant negative performance, while the basic industry, consumer goods, and mining sectors have a significantly better performance. The COVID-19 pandemic and the lockdown measures, according to this study, had a mixed impact on Indonesia’s stock market performance (Christian, 2021).

While corporate governance strategy (institution ownership) has no relationship between leverage and finance company competitiveness in Indonesia because institution ownership has not functioned as an external control mechanism (Djaddang et al., 2019), corporate governance does not influence the relationship between corporate social responsibility, earnings quality, and stock returns (independent audit committee). The audit committee’s sole responsibility is to conduct an independent audit of the consolidated financial report using auditing standards and render an opinion on the audited consolidation financial report (Djaddang et al., 2017).

The company’s sustainability was determined based on six financial indicators that predict the risk of bankruptcy. NITA, CURRAT, LTDBTTA, and the chance of bankruptcy are among the six ratios that are significant in forecasting the likelihood of bankruptcy. The possibility of bankruptcy has a significant explanatory ability according to the direction projected in the company’s sustainability viewpoint. Behn et al. (2001) used four financial ratios, namely CFTL and CACL, which are profitability measures, and solvency, LDTA, and NIBTS are measures of financial health. It is crucial in explaining the difference between companies that achieve company sustainability and companies that experience financial difficulties but do not accept the company’s sustainability view of the four financial ratios employed.

Meanwhile, CACL and NIBTS have a substantial negative link in predicting the CFTL ratio, whereas LDTA has a strong positive relationship. According to Behn et al. (2001), the default status is a significant component in explaining the company’s sustainability opinion decision and is perceived as contradictory information in the acceptance of the company’s sustainability opinion. Other research on these issues has primarily focused on negative trends and other financial concerns that are believed to be detrimental to a business.

The regulators and the policymakers need to introduce policies to eliminate momentum profits from the markets. Since some of the initiatives have already been taken by the Saudi government to re-structure the market. Foreign investment, integration of the Saudi stock market with global markets, and Vision 2030 can potentially improve the Saudi stock market’s efficiency (Khan et al., 2021). The study found that financial condition (ROA) is a stronger predictor of stock prices in Jordanian banks, and RISK substantially impacts stock prices. The researcher suggests transferring the financial condition (ROA) variable to other industries and employing a profitability factor represented by ROA, which has a strong beneficial effect on stock prices in Jordanian banks (Gharaibeh & Jaradat, 2021).

When stock returns are more volatile, the number of active investors decreases. When stock returns are less volatile, the number of active investors increases. Stock returns and volatility have an atypical relationship that can be divided into two categories: short-term and longer-term relationships. Because longer-term swings necessitate a risk premium to withstand higher risks, there is a positive link between returns and volatility. When there is a short-term fluctuation, the link between stock volatility and returns is negative. This is due to two factors. To begin with, the level of uncertainty is high, which reduces the number of trainee investors because risk awareness is at an all-time high (Yousop et al., 2021).

If the opinion is widely publicized to attract a large number of investors and the company’s financial situation is stable, it will have a positive impact. However, because investors are responsible, if the company is not stable in the face of fluctuating economic conditions, it will have a negative impact on the company (Nogler, 2006). The goal of this research was to analyze how management strategy, financial condition, and corporate governance approach affected stock returns.

2. Literature Review and Hypotheses

2.1. Stock Return

The consequence of an investment is called a return. Returns can be realized returns that have already occurred or expected returns that have not yet occurred but will in the future. The following are the two portions of the stock returns: The term “refund” refers to a re-realization that has occurred. Based on historical data, the return is determined. (1) Return realization is significant since it is used to assess a company’s success. This return can also be used as a foundation for forecasting future expectations and risks. (2), Expected Return; Expected return is the expected return on an investment in the future. Expectations have not yet been met, notwithstanding the realization that has occurred. Technical analysis, which is a study of the ongoing behavior of the capital market along with stock trading patterns, is used to analyze a company’s stock. Stocks with a good return on investment are actively traded. A dealer will not retain stock for long before exchanging it if it is actively traded. This will result in a decrease in the cost of ownership and ultimately reduce the level of the bid-ask spread (Nurmayanti, 2009).

2.2. Financial Condition

Mutchler et al. (1997), Carcello and Neal (2000), and Zhu et al. (2000) examined the role of financial variables in explaining corporate sustainability (2006). In this study, the financial situation variable is utilized to forecast the issuance of the company’s sustainability opinion or as a predictor of bankruptcy, which is the determining variable of the company’s sustainability opinion.

Bruynseels and Willekens (2006) examine the existence of short-term and long-term strategies that are part of management policy in making decisions on the company’s sustainability opinion using three financial ratios as control variables, namely the current ratio, LTDTA, and CFOTL. The results prove that the current ratio (CACL) and CFOTL are significantly negative in explaining the company’s sustainability opinion decisions.

2.3. Debt Default

According to Carcello and Neal’s (2000) research on the effect of partner compensation and company size on the company’s sustainability opinion, a total of 48 percent of companies receiving the company’s sustainability opinion encountered debt default. This occurs as a result of the company’s inability to pay debts, renegotiate debt payments, or comply with debt agreements. The size of the company, which is proxied by the total asset log, affects the decision of the company’s sustainability opinion issued by the auditor.

Because firm size is linked to public attention and possible legal requirements, a larger corporation will be more qualified. In low-litigation-risk environments, such as Hong Kong and Southeast Asian countries in general, large enterprises have a better ability to endure even when they are in financial crisis, according to Zhu et al. (2006).

2.4. Corporate Governance Structure

Companies, particularly publicly traded companies, are becoming increasingly reliant on external financings, such as money and loans. Concerning agency issues, governance, which is a notion based on agency theory, is anticipated to serve as a tool to provide investors confidence that they would get a return on their money. The structures and processes by which a firm is run are referred to as governance.

At its most basic level, governance is a process through which businesses aim to reduce transaction and agency costs associated with the business they operate (Samanta & Cerf, 2009). According to Klapper and Love (2005) and Herawaty (2008), implementing corporate governance at the corporate level has greater significance in developing countries than in developed countries. Management must adhere to the Organization for Economic Cooperation and Development’s principles of good corporate governance, which include: a) transparency (transparency), b) accountability (openness), c) responsibility (responsibility), d) independence (independence), and e) fairness (fairness) (fairness). Nogrel (2006) stated that the company’s going concern opinion will be useful for users of financial statements, especially investors.

2.5. Hypotheses

According to Nogrel (2006), auditors must give strategies, proposals, or alternatives to ensure that the company’s viability and stock returns are maintained. Stock return is influenced by management strategy, financial condition, and going concern strategy (Santosa, 2007). The hypothesis test is written as follows, based on the above:

H1: There is an effect of management strategy on stock returns.

H2: There is an effect of financial condition on stock returns

H3: There is an effect of governance structure on stock returns.

3. Methodology

This is basic research. Because the nature and objective of this research are to test a hypothesis, it is descriptive quantitative research. This research method employs a quantitative approach with a population of 1968 firms that have stock returns and a sample of 225 companies in the manufacturing industry that have corporate governance plans. The research describes a sample of 225 companies that have implemented management strategies, financial conditions, and corporate governance strategies that have an effect on stock return to increase share earnings of manufacturing companies in three sectors: the basic and chemical industry, various industries, and industrial goods. The Indonesia Stock Exchange’s stock returns from 2013 to 2018.

This study’s data is based on secondary sources. Secondary data was collected using a technique that supports data from the basic and chemical industries, as well as other industries and industrial items. Documentation of supporting data on tourism activities gathered from both governmental and non-governmental agencies makes up the supporting data in this study. The elements that influence stock returns are analyzed and tested using WarpPLS6.0 data analysis methodologies.

4. Results and Discussion

4.1. Descriptive Statistics

The results of this study indicate that management strategies, financial conditions, and governance strategies reduce the acceptance of going concern opinions and increase stock returns for investors as a means to profit center. The description of the data from this research can be seen in the descriptive statistics Table 1 below.

Table 1: Descriptive Statistics

Table 1 illustrates that the management strategy variable has an average of 11.8 rounded up to 12, meaning that the average company that carries out management strategy is 12 times during the period 2013 - June 2018 from a total of 225 companies. It shows the description of the management’s strategy for the company’s operational activities and business development in the long term during this period. The sample company’s management strategy has a maximum value of 55.99 or 56 percent and a minimum value of 2.72 times, implying that the sample company has a 2.72 times management strategy to improve financial and market performance, that is, that the sample company’s management has 3 times the opportunity to improve the company’s strategy and 10 shares outstanding and a minimum of 2.51 times the opportunity to improve market performance through a management strategy.

Table 1 shows that the average financial condition score is 8.87, indicating that the company’s financial condition has a 0.087 percent impact on financial performance through internal management performance. The sample company’s financial condition has a maximum value of 40.69 percent, and the corporate governance strategy has a value of ten (ten), implying that each sample company’s stakeholders have ten outstanding shares and a minimum of 2.51 times the opportunity to improve market performance through the corporate governance strategy.

When the standard deviation is 5.23, it means that there are multiple companies in trouble or on the edge of bankruptcy, such as PT. Toba Pulp Lestari Tbk. (INRU), with a management strategy of nil (0) and financial condition minus (–272.5) PT. Ricky Putra Globalindo Tbk. (RICY), with zero management strategy (0) and minus financial condition (–425.3333333), PT. Jembo Cable Company Tbk. (JECC), with zero management strategy (0) and minus financial condition (–138.833), PT. Wilmar Cahaya Indonesia Tbk. (CEKA) with zero management strategy (0) and minus financial condition (–158.833), PT. Taisho Pharmaceutical Indonesia Tbk. (SQBB) with a management strategy of null (0) and financial condition minus (–734.1666667), PT. Kedaung Indah Can Tbk. (KICI) with zero management strategy (0) and minus financial condition (–3469.166667), PT. Rig Tenders Indonesia Tbk. (RIGS) with zero management strategy (0) and minus financial condition (–131.1666667), and PT. Truba Alam Manunggal Engineering Tbk. (TRUB) where the management strategy is nil (0) with minus financial condition (–99.333).

A total of 225 organizations in the sample have a CG strategy, with a minimum of 2.51% and a maximum of 10% having a CG strategy, an average of 7.984 percent having a CG strategy, and 1.303 percent of sample companies having CG strategy risk. The average share income is 0.3812, or 38.12 percent of the 225 sample companies (about 85 companies), with the minimum being nil (0.00) and the maximum is 1.00, and there are 0.487 sample companies in this study proxied by the standard deviation of earnings per share showing a low-risk value, indicating that managers are very effective in controlling earnings per share to provide a stimulus and signal for investors to increase their investments.

4.2. Hypothesis Test

The output image shows the structural model equation. The structural model equation explains the relationship between exogenous variables and endogenous variables. Structural model equations in this study are as follows:

Stock returns = –0.58 SMnj + 15.62 KK – 0.18 SCG + 15.07 Size + ε.

The output significance value and path coefficient were evaluated to see whether variables had a substantial impact on the study model. The output results are shown in the table below (Table 2).

Table 2: Output Results Significance Values and Path Coefficients

Note: *p-value < 0.1; **p-value < 0.05; ***p-value < 0.001. Significant at the 0.05 level.

With the details and explanations of the following hypothesis test findings (Figure 1), it is known that there are 4 (four) factors that have a significant effect (with a significance level of 5%).

Figure 1: Stock Return Structural Model

In this study, the value of Adjusted R² is 0.62, or 62 percent, indicating that management strategy, financial condition, and CG strategy have a 62 percent impact on stock returns, while the remaining 38 percent is influenced by factors outside the research model, such as environmental, social, human capital, financial sustainability, innovation, and technology.

4.3. Discussion

4.3.1. The Effect of Management Strategy on Stock Return

The fourth hypothesis is backed by the fact that organizations in financial difficulties can improve their situation by executing a cost-cutting plan to achieve short term profitability. The proxy for cost reduction management technique, which is part of the efficiency/operational turnaround strategy, strives to stabilize operations and preserve profitability, according to empirical evidence. Empirical evidence shows that when the Japanese sample companies’ performance drops, they reduce personnel to save expenses and boost operational revenue, which is consistent with earlier studies. The results of Geiger and Rama (2003) support the findings of this investigation, which present actual evidence that cost-cutting management strategies are mitigating factors while increasing the likelihood of receiving them. According to the findings of Bruynseels and Willekens (2006), a cost-cutting strategy that involves lowering operating costs and terminating personnel is not a mitigating factor but rather reinforces the indicator that the company is experiencing a going concern problem.

4.3.2. Effect of Financial Condition on Stock Return

The linear hypothesis is backed by the fact that organizations in financial trouble can improve their situation by using a proxy management plan of cost reduction measures to raise short-term profitability (Pichelman & Hofer, 1999). According to empirical evidence, the proxied management strategy of cost reduction, part of the efficiency/operational turnaround strategy, strives to stabilize operations and preserve profitability. Empirical evidence shows that when the Japanese sample companies’ performance drops, they reduce personnel to save expenses and boost operational revenue, consistent with earlier studies.

Investors use financial conditions as a reference point while making investing decisions. The auditor’s view is not only unqualified, but it also makes investors unwilling to buy because it will damage not only stock prices but also stock returns. The findings of this study corroborate Gilson’s (2000) concept that debt restructuring is a process that replaces a debt contract with a new contract that has one or more of the following characteristics: (1) lower interest or loan principal, (2) extend the maturity, (3) shift debt to equity. If a company is accepted for debt restructuring, it indicates that its obligations to creditors will be lowered when the loan principal and interest are cut.

4.3.3. The Effect of Corporate Governance Strategy on Stock Return

Because centralized ownership can be an effective internal and external control mechanism to increase investor and potential investor confidence to increase share income/ return, which is expected to overcome the company’s financial difficulties and increase stock returns, the implementation of corporate governance strategy, which is proxied by centralized ownership of the sample companies, is significant in increasing stock return.

Since centralized ownership and independent commissioners are significant and function as internal and external control mechanisms to increase share income/ return, the study’s findings can support signaling theory and agency theory to overcome conflicts of interest and reduce agency costs, unless the audit committee has not yet functioned as an internal control and is still a lipstick and or a requirement for a company to be listed through the financial services industry.

This hypothesis assumes that the company is in a good position to apply a corporate governance plan. For example, a company in a financial crisis can sell productive assets to lower capital expenses and receive cash to help them get out of debt. The findings of this study show that the proposed hypothesis can be proven using this corporate governance technique. The corporate governance plan, on the other hand, is based on centralized ownership, which means that centralized ownership and independent commissioners are a going concern method for boosting stock returns. The study’s conclusions are similar to empirical findings by Ramadhany (2004), who found that company size influences the acceptability of going concern opinions in Indonesia.

4.3.4. The Effect of Company Size on Stock Returns

This study employs the log of total assets as a proxy for corporate scale, which has been utilized by earlier academics to define a company’s ability to fulfill short-term obligations with current assets or produce profits with its assets. As a result, large-scale businesses in financial crisis will find it simpler to overcome their difficulties than small businesses because they have more resources. Handayani et al. (2019) supported this research by stating that the results of this study indicated that firm size has an effect on stock returns. Still, the market risk has no effect on blue-chip stock returns, and firm size has a negative and significant effect on stock returns (Agustin et al., 2019).

5. Conclusion

Every company that implements a management strategy can boost stock returns, implying that if all other variables remain constant, the company’s management strategy will increase by one for each corporate governance approach implemented. This indicates that every company implementing a corporate governance strategy will see a one-time gain in stock returns.

The company that is experiencing financial distress implements a debt strategy to recover its financial condition by increasing the liquidity strategy, profitability strategy, solvency strategy, debt default strategy, and company size strategy so that the auditors see this strategy as an effort to maintain the company’s viability, resulting in increased stock returns for investors.

Implementation of corporate governance strategy as proxied by centralized ownership is important in increasing stock returns because centralized ownership can be an effective internal and external control mechanism to increase investor and potential investor confidence, resulting in increased income/return, which is expected to overcome the company’s financial difficulties and increase stock returns. The findings of this study show that the proposed hypothesis of centralized ownership and independent commissioners as a control mechanism can boost stock returns for investors while also overcoming the company’s financial challenges in the future.

The managerial suggestions/recommendations can be explained as follows:

1. According to the findings of this study, management methods, financial conditions, and governance techniques diminish the acceptability of going concern opinions and enhance stock returns for investors, as well as as a means of gaining profits.

2. Suggestions/Recommendations for investor policies can be used as a guide for investors to consider companies that implement management strategies proxied by stock, asset, debt, and cost strategies. When making investment decisions because companies that implement meaningful management strategies mitigate increasing stock returns.

3. The research’s suggestions/recommendations can be used as a guide for investors to consider companies that execute financial conditions well, as proxied by traditional financial ratios when making investment decisions because companies that execute financial conditions mean reducing stock returns.