An Empirical Comparison of Bankruptcy Models: Review

EFA
Finance
Eastern Review
Financial
The
Association
The Financial Review 33 (1998) 35-54
An empirical comparison of bankruptcy

models
Charles E. Mossman*
Faculty of Management, University of Manitoba
Geoffrey G. Bell
Doctoral Candidate, University of Minnesota
L. Mick Swartz
Dept. of Finance, Grand Valley State University
Harry Turtle
Dept. of Finance, Insurance and Real Estate, Washington State University
Abstract
Four types of bankruptcy prediction models based on financial statement ratios, cash
flows, stock returns, and return standard deviations are compared. Based on a sample of
bankruptcies from 1980 to 1991, results indicate that no existing model of bankruptcy
adequately captures the data. During the last fiscal year preceding bankruptcy, none of the
individual models may be excluded without a loss in explanatory power. If considered in
isolation, the cash flow model discriminates most consistently two to three years before
bankruptcy. By comparison,the ratio model is the best single model during the year immedi-
ately preceding bankruptcy. Quasi-jack-knifing procedures suggest that none of the models
can reliably predict bankruptcy more than two years in advance.
Keywords: Bankruptcy, prediction, financial distress
JEL classifications: G33fG34
1. Introduction
The likelihood of financial distress is an important concern about the life or
death of any enterprise. The “going concern” assumption is critical to the behavior
*Corresponding author: Charles E. Mossman, Faculty of Management, University of Manitoba,Winnipeg,

Manitoba,R3T 5V4;Telephone: (204)474-9985, Facsimile: (204)474-7545,Email: mossman@ms.umani-
toba.ca
35
36 C.E. Mossman/The Financial Review 33 (1998) 35-54
of many stakeholders both internal and external to the f i . Internal stakeholders,

such as managers and employees, are concerned with specific skills invested in the
firm that may be difficult to transfer to other enterprises. External stakeholders,
such as customers, suppliers, creditors and investors, may view the firm quite
differently in times of financial distress relative to times of prosperity.
In practice, auditors and security analysts provide a means of monitoring and
reporting the likelihood of financial distress to relevant stakeholders, particularly
those external to the f i i . Research by Beaver (1968) and Altman (1968) considered
the ability of financial ratios and models developed from ratios to identify bankruptcy
problems. Later researchers focused on models of cash flows, market returns, and
return variation.
In this study four types of bankruptcy prediction models are compared in a
unifying context. A single flagship model from each class is selected. The classes
of models include financial ratio, cash flow, market-adjusted returns, and standard
deviation models. Each model has documented descriptive or predictive ability. The
empirical framework allows an objective comparison of the models using a single
sample of firms over an identical period.‘
Results indicate that in the year prior to bankruptcy all of the models are
statistically important; however, the ratio model is the most effective in explaining
the likelihood of bankruptcy. In the three years preceding bankruptcy, the cash flow
model most consistently discriminates between bankrupt and non-bankrupt firms.
The next section briefly describes the models chosen for tests. Data and methods
are explained in the third section. The fourth section presents the empirical results.
Conclusions and implications of the findings are given in the last section.
2. Bankruptcy prediction models
2.1 Ratio models

Altman (1968) and several others (c.f., Altman, Haldeman and Narayanan,
1977; Collins, 1980; Olson, 1980; Platt and Platt, 1991) have developed accounting
ratio models of bankruptcy. Auditors often use ratio models as part of analytical
review procedures to assess the appropriatenessof the ‘‘going concern” assumption.
Security analysts use ratios as measures of the financial status of an enterprise for
valuation purposes. In the context of bankruptcy prediction, financial ratios should
vary systematically between healthy and fragile firms. Ratios such as “debt to
equity” and “current assets to current liabilities” seem intuitively related to the
probability of bankruptcy. They indicate, respectively, the ‘‘relative debt burden”
and the “relationship of liquid assets to liabilities due within one year”.
Other research which compares alternative prediction models on the same data includes Collins (1980)
and Hamer (1983).
C.E. Mossman/The Financial Review 33 (1998) 35-54 37
Although ratio models have been successfully implemented, little agreement

exists regarding the best accounting ratios to determine likelihood of financial
distress. Boritz (1991) identifies more than 65 ratios used as predictors in previous
literature. Hamer (1983) suggests that the ability of models to predict failure is
relatively independent of the ratios selected. In contrast, Karels and Prakash (1987)
advocate careful selection to improve prediction accuracy. No dominant ratio model
has emerged, although Altman’s Z (1968), and Altman, Haldeman, and Narayanan
Zeta (1977) models are very prominent.
2.2 Cash flow models

While ratio models are derived directly from financial statement accounts, cash
flow models are based on the fundamental finance principle that the value of a firm
equals the net present value of its expected future cash flows. Bankruptcy will result
if a firm has insufficient cash available to service debt outflows as they become
due, and firm value is insufficient to obtain additional financing. If current cash
flows accurately predict future financial status, then past and present cash flows
should be a good indicator of both f m value and probability of bankruptcy.
Following earlier studies by Gentry, Newbold, and Whitford (1985a, 1985b),
Aziz, Emanuel, and Lawson (1988) develop a cash flow model of bankruptcy. The
value of the firm is written as the sum of the streams of discounted cash flows to
and from operations, government, lenders and shareholders. Comparing matched
bankrupt and non-bankrupt firms, they find the group means for operating cash
flows and cash taxes paid differ significantly in all five years prior to bankruptcy.
The findings of Aziz, Emanuel, and Lawson (1988) seem intuitively reasonable.
Operating cash flows should differ between bankrupt and non-bankrupt firms, be-
cause of investment quality and operational efficiency. Tax cash flows should
also differ, because of the motivation underlying tax accounting. Although all
corporations seek to minimize tax payments, distressed companies with little or no
earnings will have no tax liabilities. Healthy firms will not be able to shelter all
their income from taxation. Therefore, they will pay promptly to avoid incurring
tax penalties.
Aziz, Emanuel, and Lawson (1989) test the accuracy of their cash flow model
predictions against Altman’s Z (1968) and Zeta (1977) models. They conclude that
the cash flow model is superior to the Z model, and gives better early warning of
bankruptcy than the Zeta model.
2.3 Return and return variation models

Beaver (1968) is one of the first researchers to consider the impact of firm
bankruptcy on stock returns. He finds that equity returns generally anticipate bank-
ruptcy sooner than financial ratios, consistent with market efficiency. Altman and
Brenner (1981) conclude that bankrupt firms experience deteriorating capital market
38 C.E. MossmanIThe Financial Review 33 (1998) 35-54
returns for at least a year prior to bankruptcy. Clark and Weinstein (1983) observe
negative market returns at least three years prior to bankruptcy. However, they find
that the announcement of bankruptcy still releases new information to the market.
Bankrupt firms average a 26% capital loss during the two month period surrounding
the bankruptcy declaration date.*
Aharony, Jones, and Swary (1980) suggest a bankruptcy prediction model
based on the variance of market returns. They find differences in the behavior of
total and firm-specific variances in returns four years before formal bankruptcy is
announced. The firm-specificcomponent of bankrupt firm return volatility increases
as bankruptcy nears.3
2.4 Bankruptcy prediction

Many variations of each of these models have been proposed to “predict”
bankruptcy. In most cases the empirical model discriminates between bankrupt
and non-bankrupt f i i s over some period before the f m status becomes known.
Typically, models are constructed ex post with full knowledge of the firms’ ensuing
bankruptcy. Accounting and financial variables are then examined to determine
whether they can classify the firms appropriately.
To provide value to practitioners, models must predict well out-of-sample.
However, they should first discriminate effectively in-sample. Empirical tests of
this study examine the discriminatory power of each class of models. Tests also
contribute to knowledge about external predictive ability through use of a data
sample that has little overlap with the original research data sets.
3. Models, data, and method
3.1 Models
Four particular examples of bankruptcy models are examined:
i) Altman’s (1968) Z model based on financial ratios;
ii) Aziz, Emanuel, and Lawson’s (1988) model comprised of cash flows;
Clark and Weinstein (1983) also compare market returns before bankruptcy for stocks which become
worthless and those which retain some value. Shares which become worthless appear to suffer greater
losses. However, bankrupt firms often do not lose their full share value upon bankruptcy due to a
reallocation of rights during the bankrvptcy process (c.f., Franks and Torous (1989)). Ramaswami (1987)
and Dugan and Forsyth (1995) investigate when market returns demonstrate investor awareness of the
financial condition of a failing firm.
Dambolena and Khoury (1980) examine the variability of financial ratios of bankrupt and non-bankrupt
firms. Ratiosof f m s approaching bankruptcy are less stable, and this instability may be related to the
increasing variability of stock returns. Measures of financial ratio variability are excluded from this
study because of the much higher frequency of stock returns available for calculation of risk measures.
Table 1
Ratio and cash flow model variables and descriptions
Panel A: Ratios-Altman’s 2 (1968)
Working Capital to Total Assets - Current Assets-current Liabilities
Total Assets
Retained Earrings to Total Assets - Retained Earnings
Total Assets
EBIT to Total Assets - Earnings Before Interest and Taxes
Total Assets
Mkt. Val. of Equity to Book Val. of Debt - Stock Price x Outstanding Shares
Long Term Liabilities and Leases
Sales to Total Assets -
- Net Sales
Total Assets
Panel B: Cash Flows-Aziz, Emanuel, and Lawson” (1988)
Earnings before interest and taxes,
Operating Cash Flows - plus depreciation, plus change in
non-debt working capital
Net Capital Investment Cash Flows - Capital Investment less proceeds
Cash Taxes Paid - Taxes paid
-
- Change in cash and marketable
Change in Liquidity
securities
Interest paid, plus net change in
Net Cash Payments to Lenders
long and short-term debt
Dividends paid, plus change in
Net Cash Payments to Shareholders
common or prefemed stock
lsAllcashflowvariablesarescaled by thebookvalue oftotal assets,as in Aziz,Emanuel,and Lawson (1988).
iii) Clark and Weinstein’s (1983) market return model; and

iv) Aharony, Jones, and Swary’s (1980) market return variation model.
Table 1 describes the ratio and cash flow model variables.
3.2 Data
The test sample includes data from U.S. firms which declared Chapter 7
or 11 bankruptcy between January 1, 1980 and December 31, 1991, as reported
in Compustat or the Wall Street Journal Index: Firms are included in the initial
Historically both Chapter 7 and Chapter 11 legislation affected firms in financial distress. Chapter 7
bankruptcy involved the wind up and dissolution of companies, while Chapter 11 concerned reorganizing
and restructuring the corporation. American bankruptcy legislation was revised in 1978, and the chapters
in current legislation are similar. Chapter X deals with pervasive reorganizations of large corporations,
while Chapter XI affects arrangements by individuals, partnerships and corporations.
sample only if all necessary financial statement data from Compustut and market
data from CRSP (NYSE, AMEX, andor NASDAQ) is available for at least
three of the five fiscal years prior to bankruptcy. As in previous studies,
financial institutions are excluded, because their ratios and cash flows are always
substantially different from those of other types of firms, even when they are
in no danger of failure.
Bankrupt and non-bankrupt firms are matched in two ways to examine possible
spurious results caused by alternative procedures. ‘‘Size-primary” matching selects
the firm nearest in total assets to the bankrupt firm, with the same 2-digit SIC
(Standard Industrial Classification) code. “Industry-primary” matching chooses
firms with the same 4-digit SICS and then finds the best total assets’ match.5
Matches are made in the earliest of the third, fourth, or fifth fiscal year of
available data prior to the bankruptcy date. Financial statement and market return
data for both bankrupt and matched firms is then assembled for the five fiscal
years prior to bankruptcy. The most recent fiscal year must end at least six
months prior to the date of bankruptcy. This fiscal year is defined as t-1. The
four previous years relative to the bankruptcy date are defined as years t-2, t-
3, t-4, and t-5.
Annual returns for both bankrupt and non-bankrupt firms are calculated each
year by compounding monthly returns during the 12 months ending with the bankrupt
firm’s fiscal year-end.6 Compound returns are included only if at least 8 of 12
months’ returns are available. Returns for months during which either the bankrupt
or matched firm does not trade are excluded. Both return series are adjusted to a
12-month equivalent through compounding to ensure comparability across paired
annual returns? Index returns are selected over the same months as individual
firm returns, and compounded to an annual equivalent. Market-adjusted returns are
calculated by subtracting either the equal-weighted or value-weighted CRSP annual
return from each firm’s annual returns.
The variation of returns model calculates a measure of total risk using the
standard deviation of total monthly returns. Measuring standard deviations using
total returns, rather than excess or abnormal returns, includes both firm-specific and
systematicrisk, which is appropriate(c.f., Aharony, Jones, and Swary, 1980).Criteria
for including or excluding a month in the standard deviation calculation are the
same as those required for the corresponding return data.
Although not necessary for logit estimation, matching allows direct comparison with previous studies.
Zmijewski (1984) shows that under certain circumstances logit tests for matched samples that differ
significantly from population proportions can lead to biased coefficients.
Using the bankrupt firm’s year-end ensures that market-wide events occurring between bankrupt and
matched company year-ends do not affect annual return comparability.
’This is accomplished by compounding gross returns to the power of lUn, where n is the number of
months with available returns.
C.E. Mossrnan/The Financial Review 33 (1998) 35-54 41
Initial financial statement data consists of 190 bankrupt and non-bankrupt U.S.
firms. Unfortunately, adding market data substantially decreases the annual sample
size, due to the limited overlap between CRSP and Compustat company data. To
consider the impact of sample size for the ratio and cash flow models, they are
tested with and without the data limitations required for inclusion of market variables.
For each year relative to bankruptcy (t- 1to t-5) the sample contains different numbers
of f m s , depending on the type of matching employed (industry or size-primary)
and whether financial market data is included.8
3.3 Individual variables

Table 2 presents year t-1 descriptive statistics for the individual explanatory
variables considered in each of the four bankruptcy models considered. Each panel
shows mean values of all variables for bankrupt firms, matched non-bankrupt firms
(according to either industry or size-primary sorting), and the combined totals for
all firms in the data sample by bankruptcy model. The final two columns of the
table present univariate t-tests for differences in means for both industry and size-
primary sample^.^
Panel A presents the ratios used in Altman’s Z (1968), defined in Table 1.
According to Altman (1968), these variables are often considered as proxies for
financial liquidity, total earnings of the firm since inception, earnings power of
assets, capital structure of the firm, and sales generating power of assets. Significant
differences between bankrupt and non-bankrupt firms (Panel A) are generally con-
sistent with Altman’s (1968) findings. Working capital to total assets, earnings
before interest and taxes (EBIT) to total assets, and market value of equity to book
value of debt differ significantly in the expected direction at the ten percent level
for both types of sample sorting. Retained earnings to total assets is also consistent
in significance and direction of relationship with Altman in the industry-primary
sample, but is not significant at the ten percent level in the size-primary sample.
(The industry-primary sample is closer in selection criteria to Altman’s than is the
size-primary sample.) As in Altman’s (1968) study, sales to total assets is not
significantly different between firms.
Panel B examines the cash flow variables of Aziz, Emanuel, and Lawson
(1988), defined in Table 1. Following Aziz, Emanuel, and Lawson (1988, 1989),
all cash flow variables are scaled by book value of total assets. Differences
between bankrupt and non-bankrupt firms for cash taxes paid and liquidity cash
In the sample which includes market data, for years t-1, t-2, t-3, t-4, and t-5 there are 72, 74, 62, 52,
and 46 f m s available, respectively, for industry-primary matching, and 90, 86, 76, 58, and 52 firms,
respectively, for size-primary matching.
The reader is cautioned that these results represent only simple relationships between bankruptcy state
and the single variable considered. Given correlation between independent variables, results must be
interpreted with care.
Table 2
R
Comparison of variable mean values for bankrupt and nonbankrupt firms values for year t-1
SIC primary (n = 72 h s ) Size Primary (n = 90 firms) Different between Means

SIC Size fi
Bankrupt Nonbankrupt Total Banlaupt Nonbankrupt Total Primary Primary h
Sample Sample Sample Sample Sample Sample T-test T-test
%
Panel A: E
Accounting Ratio Variables 3
Working capital/total assets -0.028 0.314 0.143 -0.040 0.307 0.134 3.661*** 4.273*** \
Retained earnings/total assets -0.386 0.282 -0.052 -0.331 0.038 -0.147 2.445** 1.137
EBIThotal assets -0.169 0.123 -0.023 -0.159 0.090 -0.035 2.531** 2.504** 2
Market value equityhok value debt 0.630 2.180 1.405 0.571 5.443 3.007 2.449** 1.719* g
Q
Sales/total assets 1.642 1.652 1.647 1.588 1.602 1.595 0.044 0.067 3
I?.
Panel B: E
Cash Flow Variables
Operating cash flows 0.122 0.179 0.151 0.099 0.177 0.138 0.643 1.004
P
i
Investment cash flows 0.239 0.101 0.170 0.219 0.069 0.144 1.179 1.424 2'
Tax paid cash flows 0.007 0.035 0.021 0.005 0.036 0.021 3.797*** 4.091***
Liquidity cash flows -0.078 0.023 -0.028 -0.070 0.029 -0.021 1.685* 2.045**
lu
Shareholder cash flows -0.023 -0.004 -0.013 -0.025 -0.005 -0.015 0.730 0.894
Lender cash flows 0.047 0.075 0.061 0.023 0.092 0.057 0.549 1.501 3
2
Panel C:
Market Return Variables P
12-Month compound return -0.202 0.161 -0.020 -0.222 0.167 -0.027 2.800*** 3.548***
60-Month compound return 0.292 1.143 0.718 0.159 1.309 0.734 1.922* 2.844***
12-Month mkt-adj return; value-wtd index -0.309 0.054 -0.128 -0.321 0.067 -0.127 2.996*** 3.848***
60-Month mkt-adj return; value-wtd index -0.519 0.331 -0.094 -0.647 0.503 -0.072 1.943* 2.876***
12-Month mkt-adj return; equal-wtd index -0.296 0.067 -0.115 -0.294 0.094 -0.100 3.244*** 4.169***
60-Month mkt-adj return; equal-wtd index -1.026 -0.176 -0.601 -0.998 0.152 -0.423 1.929* 2.946***
Table 2 (continued)
~~
Panel D:
Variation of Returns Variables
12-Month standard deviation of returns 0.148 0.124 0.136 0.151 0.130 0.141 1.564 1.201
60-Month standard deviation of returns 0.156 0.134 0.145 0.157 0.136 0.147 1.598 1.834*
1. Significance levels: * statistically significant at 0.10 level

** statistically significant at 0.05 level Fs.
*** statistically significant at 0.01 level 2
2. “SIC Primary” and “Size Primary” refer to the matching criteria for bankrupt and non-bankrupt (matched) f m s for a test. For “SIC primary”, we match
Lu
exactly on 4-&git SIC codes, then choose the closest matched firm by size (total assets). For “Size primary”, we choose the fm closest in size (total assets) Lu
with a close, but not necessarily exact, SIC. All companies fall within the same 2-digit SIC.
flows are significant at the ten percent level; however, operating cash flows are
not significantly different. The significant difference between liquidity cash flows
is consistent with the difference in the working capital ratios found in Panel A.
Panel C examines market return variables, identified by Clark and Weinstein
(1983). Several alternative return measures for 12 and 6O-month holding periods
are considered. Not surprisingly, realized market-adjusted returns for the bankrupt
sample are negative, indicating that the market adjusts stock prices downward,
as the probability of bankruptcy increases. Panel D reports results for variation
of returns variables. The expected comparative value relationships between
bankrupt and non-bankrupt firms prevail for both measures of standard deviation;
however, neither alternative displays strong discriminatory ability.
For brevity, univariate t-test results are reported only at relative year t-1. Results
for the preceding years are similar, but weaker. In the size-primary sample, EBITI
Total Assets and Tax Paid Cash Flows are significantly different between bankrupt
and non-bankrupt firms throughout the full five years prior to bankruptcy. The ratios
of working capital to total assets (WC/TA) are significantly different only in year
t-1, as are market equity to book debt ratios. WC/TA is expected to be a short-term
liquidity indicator, consistent with standard financial analysis. Liquidity cash flows,
returns and return standard deviations discriminate significantly some years before
t-1, but not consistently every year. All other variables have insignificant differences
before year t- 1.
3.4 Method
Altman (1968) and Altman, Haldeman and Narayanan (1977) use multiple
discriminant analysis (MDA) to develop bankruptcy “prediction” formulas. MDA
classifies data into discrete categories, and establishes a boundary equation which
maximizes discriminationbetween categories. However, MDA requires the unlikely
assumption that independent variables for bankrupt and non-bankrupt firms have
identical, normal distributions.
Later research examining bankruptcy (e.g., Ohlson 1980; and Aziz, Emanuel,
and Lawson 1988, 1989) favors logistic regression (logit) over MDA for both
theoretical and empirical reasons. Logit requires less restrictive statistical assump-
tions, and offers better empirical discrimination (c.f., Zavgren, 1983). Therefore,
tests use logistic regression (logit), with bankruptcy state as the dependent variable
and independent variables given by the models selected.
For comparability with the original studies, results are first reported for each
model in isolation. A comprehensive, unrestricted model, including independent
variables from all four model types, is then constructed. Standard likelihood
ratio (LR) tests then determine whether the exclusion of any model is significant.
4. Empirical results
4.1 Individual models

Table 3 presents the empirical evidence for the individual bankruptcy models.’0
The reported p-values show that individually, the only model which does not discrim-
inate strongly the last year before bankruptcy is the return variation model with a
year t-1 p-value of 0.178 in the size-primary and 0.235 in the industry-primary (SIC
primary) samples respectively. The variation model also has the lowest percentage
of concordant (in-sample correct classification) predictions. The LR statistics for
the other three models all are significant at the one percent level.
For year t-1, the ratio model best classifies firms. Table 3 shows that 84.9%
(83.9%) of all size-primary (industry-primary) firms are concordant with model
allocation. The cash flow model follows closely, accurately classifying 84.0%
(82.6%) of f m s in-sample when size (industry) matching is used. Return and
variation models display poorer ability to discriminate between bankrupt and non-
bankrupt firms during the last two years.
The bankrupt and non-bankrupt classification columns report discrimination
results using a quasi-jack-knife procedure.” Each firm is predicted as bankrupt or
non-bankrupt based on data from the rest of the sample. The fiftieth percentile
results are presented, since the sample composition of 50% bankrupt and 50% non-
bankrupt firms is known before testing. (A researcher could choose to have only a 5%
probability of misclassifying bankrupt firms, but would increase the non-bankrupt
classification error.)
Prediction results in Table 3 differ from those of the original researchers, due
to differing data sets and criteria. The table reports percentages of correct “out-of-
sample” prediction of bankrupt and non-bankrupt companies by model. None of
the models performs particularly well more than two years prior to bankruptcy.
The industry-primary sample is slightly smaller than the size-primary sample,
due to the unavailability of 4-digit SIC code matches with complete data for some
bankrupt firms. Restricting the sample to include only bankrupt companies available
for both types of matching reveals that differences in significance by industry and
size are mainly due to differing sample sizes. There is no clear advantage to matching
first by size or by industry.
lo Tests focus on annualized 12 and 60 month returns in excess of the equal-weighted index, based on
the similarity in results reported in Table 2. Inclusion of excess returns on the value-weighted index has
no significant effect. The 12 and 60 month standard deviations of total returns are used in all tests.
Shareholder cash flows are omitted from the cash flow model to avoid a data matrix singularity (c.f.,
Aziz, Emanuel, and Lawson, 1988, 1989). Logistic estimation makes use of SAS “PROC LOGIST”.
’’This procedure is the “CTABLE’ option under SAS “PROC LOGIST”. It creates a consistent
estimator of the prediction error.
Table 3
Logistic regression analysis for individual models
SIC Primary Size Primary

Correct Classification Correct Classification
Covariate Covariate
LR Stat P-value Concordant Bankrupt Non-Bank. LR Stat P-value Concordant Bankrupt Non-Bank
~ ~~ ~~~ .
Panel A: Year t-1 n = 12 n = 90
Ratio variables only (dof = 5) 45.14 O.OO0 83.9% 77.8% 67.4% 55.37 0.000 84.9% 80.0% 71.1%
Cash flow variables only (dof = 5) 24.26 0.OOO 82.6% 63.9% 72.2% 33.85 0.0oo 84.0% 71.1% 68.9%
Returns variables only (dof = 2) 10.79 0.005 74.1% 52.8% 69.4% 18.50 0.0oo 76.4% 66.7% 57.8%
Variance variables only (dof = 2) 2.90 0.235 65.4% 66.7% 47.2% 3.45 0.178 62.9% 62.2% 42.2%
Panel B: Year t-2 n = 74 n = 86
Ratio variables only 4.94 0.424 66.7% 56.8% 43.2% 11.21 0.047 72.1% 58.1% 58.1%
Cash flow variables only 6.99 0.222 69.5% 62.2% 43.2% 14.74 0.012 73.2% 58.1% 60.5%
Returns variables only 1.01 0.603 58.1% 43.2% 54.1% 1.80 0.406 58.9% 46.5% 60.5%
Variance variables only 2.19 0.334 63.7% 56.8% 48.6% 4.78 0.092 67.2% 62.8% 60.5%
Panel C: Year t-3 n = 62 n = 76 4,
4,
Ratio variables only 2.28 4
0.809 63.6% 48.4% 35.5% 6.00 0.306 62.5% 48.7% 44.1%
Panel D: Year t-4 n = 52 n= 58
Table 3 continued
Logistic regression analysis for individual models
~~
Panel E Year t-5 n = 46 n = 52

The sample size (n) for each year is the number of firms using SIC or Size-based matching (4-digit SIC or 2-digit SIC and closest total assets).
The LR statistics (-2 log LR) have Chi-square distributions, with degrees of freedom (don equaling the number of independent variables. Degrees of
freedom are equal for every year (t-1 to t-5). In the cash flow model, shareholder cash flows are omitted to avoid a data matrix singularity. AU cash flow
variables are scaled by book value of total assets. In the returns model, only the 12 and 60-month returns, adjusted by subtracting the equal-weighted
market index are included.
The concordant columns show the percentage of all firms classified correctly in-sample. The Bankrupt and Non-Bank Classification columns show the
percentages of bankrupt and non-bankrupt companies classified correctly when each company is iteratively withheld from the sample.
48 C.E. Mossrnan/The Financial Review 33 (1998) 35-54
4.2 Nested tests for all models

Table 4 presents the results of empirical model selection tests, considering
whether any model may be eliminated from the comprehensive model. LR tests
examine whether exclusion of an individual bankruptcy model is a binding restric-
tion.12 Results for the size-primary sample in year t-1 demonstrate that each of the
four bankruptcy models considered are statistically important at the five percent
level. Given earlier comparisons, the marginal insignificance of the market-based
models for the industry-primary sample is likely due to a smaller, less-informative
sample. Thus, the size-primary sample is stressed for the remaining findings. Notice
that individually, none of the existing models adequately captures the bankruptcy
process for year t-1.
In years t-2 and t-3, the relative explanatorypower of the component bankruptcy
models within the comprehensive model deteriorates. Only the cash flow model
remains statistically significant at conventional levels for all three years preceding
bankruptcy. The insignificance of the exclusion tests for the ratio model in years
t-2 and t-3 suggests that the cash flow model provides the best early warning of
bankrupt~y.’~ Market-adjusted returns and return standard deviations are less stable
in discriminatory ability during years t-1 to t-3.
4.3 Ratio and cashflow model tests

Limited data on bankrupt company CRSP returns greatly decreased the number
of available firms in the initial sample. To examine the sensitivity of the initial
results to sample size the ratio and cash flow models, which use only Compustat
data, are re-examined. Limiting the data to Compustat allows a substantial increase
in number of firms. However, an additional assumption that “book value of equity
to book value of debt” is a good proxy for “market value of equity to book value
of debt” is needed.14
Using the larger sample, Table 5 c o n f i i s the results of Table 4.Although the
modified ratio model has more explanatory power when compared only with the
cash flow model, neither model satisfactorily explains the data in the larger sample
more than three fiscal years prior to bankruptcy. Moreover, exclusion of the ratio
model results in an insignificant Chi-square test statistic at conventional levels for
periods more than two years prior to bankruptcy. Generally, tests on the ratio and
cash flow models are consistent with earlier findings in smaller samples.
’*The LR test statistic is 2(Lu - LR),where Lu and LR are the log-likelihoods of the unrestricted and
restricted models. This LR statistic is distributed chi-square, with degrees of freedom equalling the
number of excluded parameters.
Standardization of ratios by industry may improve their relative predictive power (c.f., Platt and Platt,
l3
1991). However, Sheppard (1994) presents evidence that gains from industry standardization are small.
l4 The effect of substituting this ratio in our original smaller samples led to comparable results, although
the ratio model is hampered slightly, as expected.
Table 4
Nested test results for all models
SIC Primary Size Primary
Covariate Degrees of Covariate Degrees of
LR Stat LR Test freedom P-Value LR Stat LR Test freedom P-Value
n
t?
Panel A: Year t-1 n = 72 n = 90
Comprehensive model 60.53 84.46
Excluding ratio model 37.40 23.14 5 O.OO0 46.52 37.94 5 O.OO0
Excluding cash flow model 47.77 12.76 5 0.026 59.50 24.96 5 O.OO0
Excluding returns model 56.14 4.40 2 0.111 77.35 7.12 2 0.029
Excluding variance model 56.59 3.94 2 0.139 77.60 6.86 2 0.032
Panel B: Year t-2 n = 74 n = 86
Excluding ratio model 8.81 1.32 5 0.933 16.81 6.89 5 0.229
Excluding cash flow model 6.45 3.68 5 0.596 13.46 10.23 5 0.068
Excluding variance model 9.32 0.81 2 0.668 21.77 1.92 2 0.383
Panel C Year t-3 n = 62 n = 76 4,
4,
Excluding returns model 18.37 11.60 2 0.003 20.27 5.80 2 0.055 4,
Excluding variance model 25.72 4.24 2 0.120 25.21 0.86 2 0.650 ;"
Panel D: Year t-4 n = 52 n = 58 2
Excluding variance model 4.35 0.96 2 0.618 7.66 4.90 2 0.087 P
v)
Table 5
Nested test results for ratio and cash flow models
SIC Primary Size primary
Covariate Degrees of Covariate Degrees of
LR Stat LR Test freedom P-Value LR Stat LR Test freedom P-Value
Panel A: Year t-1 n = 128 n = 160
Combined Models 51.56 71.61
Excluding ratio model 31.67 19.89 5 0.001 46.60 25.01 5 O.OO0
Panel B: Year t-2 n = 140 n = 170
Excluding cash flow model 15.29 9.11 5 0.105 32.68 16.96 ~~~~~~~
5 0.005
Panel C: Year t-3 n = 136 n = 166
Combined Models 19.53 25.1 1
Panel D Year t-4 n = 132 n = 154
Panel E: Year t-5 n = 112 n = 138
1. This table shows results when only ratio and cash flow variables are included in the analysis. Altman's Equity to Debt (X4) uses book value of equity,
instead of market value. Returns are excluded to increase sample size.
2. The sample size (n) of reach year is the number of SIC Primary or Size Primary f m .
3. LR Test statistics equal the difference between -2 log LR for the unrestricted and restricted models. They are distributed Chi-square with degrees of freedom
equal to the number of variables restricted to zero.
5. Conclusion
Tests of bankruptcy prediction models show that no single model proposed in
the existing literature is entirely satisfactory at differentiating between bankrupt and
non-bankrupt firms. The discriminatory ability of the cash flow model remains
relatively consistent over the last two to three fiscal years before bankruptcy, while
the ratio model offers the best discriminatory ability in the year immediately prior
to bankruptcy.
These results suggest different uses for the models. Stakeholders might be
particularly interested in cash flow variables as an “early warning” of potential
financial difficulties.Alternatively, a large negative shift in accountingratio variables
could be a useful indicator of imminent financial collapse. These findings must be
tempered with a caveat: none of the models is particularly reliable in discriminating
more than three years prior to bankruptcy.
The usefulness of ratio and cash flow variables is substantial in comparison
with the use of market returns in isolation. Market return and return variation models
do not subsume financial ratio and cash flow models. The challenge for new research
is to make full use of all readily available data within a better model of the bankruptcy
process.
References
Aharony, J., C. Jones, and I. Swary, 1980. An analysis of risk characteristics of corporate bankruptcy
using capital market data, Journal of Finance 35, 1001-1016.
Altman,E., 1968. Financial ratios, discriminant analysis and the prediction of corporate bankruptcy,
Journal of Finance 4, 589-609.
Altman, E. and M. Brenner, 1981. Information effects and stock market response to signs of f m
deterioration, Journal of Financial and Quantitative Analysis 16, 35-51.
Altman, E., R. Haldeman, and P. Narayanan, 1977. Zeta analysis-a new model to identify bankruptcy
risk of corporations, Journal of Banking and Finance 1, 29-54.
Aziz, A., D. Emanuel and G. Lawson, 1988. Bankruptcy prediction-an investigation of cash flow based
models, Journal of Management Studies 25, 419-437.
Aziz, A., and G. Lawson, 1989. Cash flow reporting and financial distress models: testing of hypotheses,
Financial Management Spring, 55-63.
Beaver, W., 1968. Market prices, financial ratios, and the prediction of failure, Journal of Accounting
Research, 179-192.
Boritz, J., 1991. The “going concern” assumption: accounting and auditing implications, Research
Reporr, Canadian Institute of Chartered Accountants (CICA) (CICA: Toronto, Canada).
Clark, T., and M. Weinstein, 1983. The behaviour of common stock of bankrupt fims, Journal of
Finance 38, 489-504.
Collins, R., 1980. An empirical comparison of bankruptcy prediction models, FinanciaE Management
Summer, 51-57.
Dambolena, I., and S. Khoury, 1980. Ratio stability and corporate failure, Journal of Finance 35,
1017-1027.
Dugan, M., and T. Forsyth, 1995. The relationship between bankruptcy model predictions and stock
market perceptions of bankruptcy, The Financial Review 30, 507-528.
Franks, J., and W. Torous, 1989. An empirical investigation of U.S. firms in reorganization, Journal of
Finance 44,747-769.
Gentry, J., P. Newbold, and D. Whitford, 1985a.Classifying bankrupt f m s with funds flow components,
Joumul of Accounting Research 23, 146-160.
Gentry, J., P. Newbold, and D. Whitford, 1985b. Predicting bankruptcy: if cash flow’s not the bottom
line, What Is?, Financial Analysts Journal, September/October, 47-56.
Hamer, M.1983.Failure prediction: sensitivity of classification accuracy to alternative statisticalmethods
and variable sets, Journal of Accounting and Public Policy 2, 289-307.
Kareis, G., and A. Prakash, 1987. Multivariate normality and forecasting business bankruptcy, Journal
of Business, Finance and Accounting 14, 573-593.
Ohlson, J., 1980. Financial ratios and the probabilistic prediction of bankruptcy, Journal of Accounting
Research 18, 109-131.
Platt, H., and M. Platt, 1991. A Note on the use of industry relative variables in bankruptcy prediction,
Journal of Banking and Finance 15, 1183-1194.
Ramaswami, M., 1987. Stock market perception of industrial f m bankruptcy, The Financial Review
2, 267-279.
Sheppard, J., 1994. The dilemma of matched pairs and diversified firms in bankruptcy prediction models,
Mid-Atlantic Journal of Business 30, 9-25.
Zavgren, C., 1983. The prediction of corporate failure: the state of the art, Journal of Accounting
Literature Spring, 1-38.
Zmijewski, M., 1984. Methodological issues related to the estimation of financial distress prediction
models, Journal of Accounting Research 22 Supplement, 59-86.

An Empirical Comparison of Bankruptcy Models: Review

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

An Empirical Comparison of Bankruptcy Models: Review

Uploaded by

Copyright:

Available Formats

EFA

An empirical comparison of bankruptcy

*Corresponding author: Charles E. Mossman, Faculty of Management, University of Manitoba,Winnipeg,

of many stakeholders both internal and external to the f i . Internal stakeholders,

2. Bankruptcy prediction models

2.1 Ratio models

Although ratio models have been successfully implemented, little agreement

2.2 Cash flow models

2.3 Return and return variation models

2.4 Bankruptcy prediction

3. Models, data, and method

lsAllcashflowvariablesarescaled by thebookvalue oftotal assets,as in Aziz,Emanuel,and Lawson (1988).

iii) Clark and Weinstein’s (1983) market return model; and

3.3 Individual variables

SIC primary (n = 72 h s ) Size Primary (n = 90 firms) Different between Means

1. Significance levels: * statistically significant at 0.10 level

4.1 Individual models

SIC Primary Size Primary

Panel E Year t-5 n = 46 n = 52

4.2 Nested tests for all models

4.3 Ratio and cashflow model tests

You might also like