Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy

Introduction

ACADEMICIANS seem to be moving toward the elimination of ratio analysis as an analytical technique in assessing the performance of the business enterprise. Theorists downgrade arbitrary rules of thumb, such as company ratio comparisons, widely used by practitioners. Since attacks on the relevance of ratio analysis emanate from many esteemed members of the scholarly world, does this mean that ratio analysis is limited to the world of "nuts and bolts"? Or, has the significance of such an approach been unattractively garbed and therefore unfairly handicapped? Can we bridge the gap, rather than sever the link, between traditional ratio "analysis" and the more rigorous statistical techniques which have become popular among academicians in recent years?

The purpose of this paper is to attempt an assessment of this issue-the quality of ratio analysis as an analytical technique. The prediction of corporate bankruptcy is used as an illustrative case.l Specifically, a set of financial and economic ratios will be investigated in a bankruptcy prediction context wherein a multiple discriminant statistical methodology is employed. The data used in the study are limited to manufacturing corporations.

A brief review of the development of traditional ratio analysis as a technique for investigating corporate performance is presented in section I. In section I1 the shortcomings of this approach are discussed and multiple discriminant analysis is introduced with the emphasis centering on its compatibility with ratio analysis in a bankruptcy prediction context. The discriminant model is developed in section 111,where an initial sample of sixty-six firms is utilized to establish a function which best discriminates between companies in two mutually exclusive groups: bankrupt and non-bankrupt firms. Section IV reviews empirical results obtained from the initial sample and several secondary samples, the latter being selected to examine the reliability of the discriminant model as a predictive technique. In section V the model's adaptability to practical decision-making situations and its potential benefits in a variety of situations are suggested. The final section summarizes the findings and conclusions of the study, and assesses the role and significance of traditional ratio analysis within a modern analytical context.

Traditional Ratio Analysis

The detection of company operating and financial difficulties is a subject which has been particularly susceptible to financial ratio analysis. Prior to the development of quantitative measures of company performance, agencies were established to supply a qualitative type of information assessing the creditworthiness of particular merchants. Formal aggregate studies concerned with portents of business failure were evident in the 1930's. A study at that time3 and several later ones concluded that failing firms exhibit significantly different ratio measurements than continuing entities.* In addition, another study was concerned with ratios of large asset-size corporations that experienced difficulties in meeting their fixed indebtedness obligation. A recent study involved the analysis of financial ratios in a bankruptcy-prediction context. This latter work compared a list of ratios individually for failed firms and a matched sample of non-failed firms. Observed evidence for five years prior to failure was cited as conclusive that ratio analysis can be useful in the prediction of failure. The aforementioned studies imply a definite potential of ratios as predictors of bankruptcy. In general, ratios measuring profitability, liquidity, and solvency prevailed as the most significant indicators. The order of their importance is not clear since almost every study cited a different ratio as being the most effective indication of impending problems.