Proceedings of ASBBS

Volume 17 Number 1

FINANCIAL RATIOS AND THE PREDICTION OF BANKRUPTCY: THE OHLSON MODEL APPLIED TO CHINESE PUBLICLY TRADED COMPANIES
Wang, Ying Montana State University-Billings E-mail: ywang@msubillings.edu Campbell, Michael Montana State University-Billings E-mail: mcampbell@msubillings.edu
ABSTRACT This study re-examines the well-known Ohlson (1980) model on firm failure prediction. The data come from china publicly listed companies and cover a range of 11 years (1998-2008). The Ohlson (1980) model is re-estimated and then revised to better fit the specific situation of China publicly listed companies. The result shows that OENEG (if total liabilities exceeds total assets, 0 otherwise) and INTWO (1 if net income was negative for the last two years, 0 otherwise) are the two most influential variables in failure prediction and are significant at p<.01. This study contributes to the literature by expanding the application of Ohlson (1980) model to China publicly listed companies. It provides applicable measures for predicting firm delisting events in China stock markets. INTRODUCTION In what way can financial data add depth to our understanding of why some firms cease growing, discontinue, fail, or go into bankruptcy? Big 10 Tire Stores Inc, Chrysler and General Motors have filed for bankruptcy protection. Thurston (2009) reports a 28% increase in overall bankruptcy filings and a 29% increase in commercial bankruptcy filings in February 2009 due to local and global recessions that exert pressure on island businesses and personal finances in Puerto Rico. The Chinese economy is significantly affected by the 2008-9 global financial crisis due to the export orientated nature of the economy which depends heavily upon international trade. China is experiencing the hit of business failure. The pearl tri-angle, famous for its shoe production, now is quiet and confused. Thousands of shoe companies there have closed. Huaqiang, the biggest plastic producer in China, has declared bankruptcy in 2008, leaving 7000 people jobless. China experienced the first increase of Bankruptcy cases in 2007 (3207 cases) starting from 2002. 1 How can we protect investors from this type of loss? There are a number of careful research studies using data from United States firms that provide various methods to identify failing firms. Currently, the two most widely used models are Altmans Z score model (Altman, 1968) and Ohlsons model (Ohlson, 1980). After the establishment of Altmans Z score model, abundant studies have done further research on the z score model, including Deakin(1972), Edmister (1972), Taffler (1982), Taffler (1983), Goudie (1987), Grice and Ingram (2001), Agarwal and Taffler (2007), Boritz, Kennedy, and Sun (2007), Sandin and Porporato (2007). Many studies also have been done relevant to the Ohlson model, including Lau (1987), Boritz, Kennedy, and Sun (2007), Muller, SteynBruwer, and Hamman (2009), Beneda (2007), Das, Hanouna, and Sarin (2009).
1

China Experiencing Bankruptcy Surge? news.QQ.com, 3/27/2008.

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Proceedings of ASBBS

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The objective of this paper is to expand the application of Ohlsons model by reestimating the model based on Chinese publicly listed companies financial data. In Section II of this paper, we summarize major relevant previous research. Section III describes the methodology. Section IV illustrates results ,followed by a conclusion in Section V. PREVIOUS STUDIES The prediction of company failure has been well researched using developed country data (Beaver 1966; Altman 1968; Wilcox 1973; Deakin 1972; Ohlson 1980; Taffler 1983; Boritz, Kennedy and Sun 2007). A variety of models have been developed in the academic literature using techniques such as multiple discriminant analysis (MDA), logit, probit, recursive partitioning, hazard models, and neural networks. Summaries of the literature are provided in Zavgren (1983), Jones (1987), Oleary (1998), Boritz, Kennedy and Sun (2007) and Agarwal and Taffler (2007). Despite the variety of models available, both the business community and researchers often rely on the models developed by Altman (1968) and Ohlson (1980) (Boritz et al. 2007). A survey of the literature shows that the majority of international failure prediction studies employ MDA (Altman 1984; Charitou et al. 2004). A brief review of a few of the studies relevant to this article follows. Beaver (1966) presented empirical evidence that certain financial ratios, most notably cash flow/total debt, gave statistically significant signals well before actual business failure. Altman (1968) extended Beavers (1966) analysis by developing a discriminant function which combines ratios in a multivariate analysis. Altman found that his five ratios outperformed Beavers (1966) cash flow to total debt ratio. Ohlson raised questions about the MDA model, particularly regarding the restrictive statistical requirements imposed by the model (Ohlson 1980). To overcome the limitations, Ohlson (1980) employed logistic regression to predict company failure. He used the logit model and US firms to develop an estimate of the probability of failure for each firm. He argued that this method overcomes some of the criticisms of MDA, which requires an assumption of a normal distribution of predictors, and suffers from the arbitrary nature of identifying non-failed matching firms. Ohlson selected nine independent variables that he thought should be helpful in predicting bankruptcy, but provided no theoretical justification for the selection. (The nine variables are described in the methodology section of this paper.) Ohlson then selected industrial firms from the period 1970-1976 that had been traded on a US stock exchange for at least 3 years. He ended up with 105 failed firms and 2000 non failed firms. Three models were estimated: the first to predict failure within 1 year, the second to predict failure within 2 years and the third to predict failure in 1 or 2 years. He then used a logistic function to predict the probability of failure for the firms using each model. Following up on concerns about the MDA model, Lau (1987) used US companies and extended the logit model concept by using five categories of firm financial health ranging from financial stability to bankruptcy and liquidation. This methodology allows calculation of the probability that a firm will move into each of the categories and, provides a better approximation to the continuum of alternative financial judgment and actions in reality. Two additional studies evaluated the effectiveness of various failure prediction models. Using data on South African companies listed on the Johannesburg Stock Exchange, Muller, SteynBruwer and Hamman (2009) tested the effectiveness of four different techniques used to predict financial distress. They found that multiple discriminant analysis and recursive partitioning have the highest prediction accuracy for predicting failed companies. They view this as the most important type of accuracy, since the cost of misclassifying failed firms, is much higher for the investor than misclassifying ASBBS Annual Conference: Las Vegas 335 February 2010

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firms that actually do not fail. Logit analysis and neural networks were found to have the highest overall predictive accuracy. Beneda (2006) investigated returns, bankruptcies and firm distress for new US public companies that issued IPOs from 1995 through 2002. Beneda found that the average first year returns for IPO companies under-performed the market and that Ohlsons model was effective in identifying companies that had a higher probability of bankruptcy and financial distress and earned lower than average returns. CONCLUSION This study re-estimated the Ohlson model using data from China publicly listed companies. The results confirm that delisting is a predictable event. The models prediction accuracy rate is in general above 95%, depending on the cutoff point selected. We further applied a backward procedure and choose five out of the nine original variables used in Ohlsons model (TLTA, WCTA, CLCA, OENEG, INTWO). The results were similar to the results when all nine variables were used. For all the estimated models, OENEG (1 if total liabilities exceeds total assets, 0 otherwise) and INTWO (1 if net income was negative for the last two years, 0 otherwise) are significant at p<.01. This paper contributes to the literature by expanding the application of Ohlson (1980) model to China publicly listed companies. It provides applicable measures for predicting firm delisting events in China stock markets. Future research comparing Ohlson (1980) and Altman (1968) z-score models and the revised corresponding models applicable to China using ex-ante data will provide meaningful insights.

ASBBS Annual Conference: Las Vegas

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Proceedings of ASBBS REFERENCES

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Agarwal, Vineet and Richard J. Taffler ( 2007). Twenty-five Years of the Taffler Z-score Model: Does It Really Have Predictive Ability? Accounting and Business Research, Volume 37, Number 4, 285-300. Altman, Edward I. (1968). Financial ratios, discriminant analysis and the prediction of corporation bankruptcy. The Journal of Finance, Volume 23, 589-609 Boritz, J. Efrim, Duane B. Kennedy, and Jerry Y. Sun (2007). Predicting Business Failure in Canada. Accounting Perspectives, Volume 6, Number 2, 141-65. Deakin, Edward B. (1972). A Discriminant analysis of Predictors of Business Failure. Journal of Accounting Research, Volume 10, 167-79. Edmister, Robert O. (1972). An Empirical Test of Financial Ratio Analysis for Small Business Failure Prediction. The Journal of Financial and Quantitative Analysis, Volume 7, Number 2, 14771493. Goudie, A. W. (1987). Forecasting Corporate Failure: The Use of Discriminant Analysis within a Disaggregated Model of the Corporate Sector. Journal of the Royal Statistical Society, Series A (General) 150, Number 1, 69-81. Grice, John Stephen and Robert W. Ingram (2001). Tests of the Generalizability of Altman's Bankruptcy Prediction Model. Journal of Business Research, Volume 54, Number 1, 53-61. Ohlson, J.A. (1980). Financial ratios and the probabilistic prediction of bankruptcy. Journal of Accounting Research, Volume 18, Number 1, 109-31. Sandin, Ariel and Marcela Porporato (2007). Corporate Bankruptcy Prediction Models Applied to emerging Economies: Evidence from Argentina in the Years 1991-1998. International Journal of Commerce and Management, Volume 17, Number 4, 295-311. Taffler, Richard J. (1982). Forecasting company failure in the UK using discriminant analysis and financial ratio data. Journal of the Royal Statistical Society, Volume 145, Number 3, 342-358. Taffler, Richard J. (1983). The Assessment of company solvency and performance using a statistical model. Accounting and Business Research, Volume 15, Number 52, 295-308. Thurston, Lawson D. (2009). Bankruptcies continue to rise sharply. Caribbean Business, Volume 37, Number 14, 10. Muller, G.H., B.W. Steyn-Bruwer, and W.D. Hamman. 2009. Predicting financial distress of companies listed on the JSE-A comparison of techniques. South African Journal of Business Management, Volume 40, Number 1, 21-32. Lau, Amy Hing-Ling (1987). A Five-State Financial Distress Prediction Model. Journal of Accounting Research, Volume 25, Number 1, 127-138. Beneda, Nancy (2007). Performance and distress indicators of new public companies. Journal of Asset Management, Volume 8, Number 1, 24-33. ASBBS Annual Conference: Las Vegas 337 February 2010

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Das, Sanjiv R. Paul Hanouna, and Atulya Sarin (2009). Accounting-based versus market-based crosssectional models of CDS spreads. Journal of Banking & Finance, Volume 33, Number 4, 719730.

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