Corporate Financial Distress A Study of The Italian Manufacturing Industry

SPRINGER BRIEFS IN FINANCE
Matteo Pozzoli
Francesco Paolone
Corporate
Financial Distress
A Study of
the Italian
Manufacturing
Industry
123
SpringerBriefs in Finance
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Matteo Pozzoli • Francesco Paolone
Corporate Financial Distress

A Study of the Italian Manufacturing Industry
Matteo Pozzoli Francesco Paolone
Department of Law Department of Accounting, Business and
Parthenope University of Naples Economics
Naples, Italy Parthenope University of Naples
Naples, Italy
ISSN 2193-1720 ISSN 2193-1739 (electronic)

SpringerBriefs in Finance
ISBN 978-3-319-67354-7 ISBN 978-3-319-67355-4 (eBook)
DOI 10.1007/978-3-319-67355-4
Library of Congress Control Number: 2017951120
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Preface
Companies have experienced bankruptcy throughout history. Bankruptcy results in

financial harm to investors and creditors and to the economy in general. It has
therefore been a topic of study for students and researchers alike with particular
focus on the predictability of a bankruptcy.
This book presents one of the most current trends in the field of finance and
accounting: corporate financial distress and risk seen from an Italian perspective.
We provide a review of all research methods of financial distress and bankruptcy
modeling based on prior academic literature. From there, we start to implement our
model of financial distress risk prediction in an Italian context.
In finance and accounting research, failure prediction models may be used as a
diagnostic tool in many different contexts. For this reason, each context has a
unique model of prediction that best fits with the characteristics of the firms.
This study was inspired by the empirical analysis of financially distressed Italian
companies which operate in manufacturing industries, and it contributes new
insights into this already extended and complex field of accounting and financial
research.
We aim to provide a comprehensive theoretical framework of the statistical
models of corporate failure. In such instances, we formulate a well-tested general
model based on a logistic regression that works reliably and consistently in an
Italian context.
Based on our empirical tests in this study, our reestimated version of the Altman
model, containing the five study variables with coefficients reestimated using a
large dataset of Italian manufacturing firms (9302 Active companies vs. 783 failed
during the period 2007–2015), works consistently and is easy to implement and
interpret.
Thus, this kind of accounting-based model can be adopted by all interested
parties, especially internationally active banks, practitioners, researchers, and
other financial institutions, not only for bankruptcy or financial distress prediction
but also for other managerial purposes such as provisioning and economic capital
calculation.
v
vi Preface
The aim of this book is to allow all Italian manufacturing Public Limited
Companies (S.p.A.) to adopt tools able to predict the risk of bankruptcy and to
better interpret the causes related to it.
The global business environment determines the international financial flow and
the demand for international harmonization of accounting. However, the field of
global finance and accounting has encountered some new challenges; corporate
financial distress is still important in today’s business, and a more consistent tool to
assess financial distress would allow us to better deal with the global crisis and to
take action in order to prevent it.
Naples, Italy Matteo Pozzoli

Naples, Italy Francesco Paolone
Contents
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
2 Defining Corporate Financial Distress and Bankruptcy . . . . . . . . . . . 3
2.1 Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.2 From Decline to Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.3 From Crisis to Financial Distress . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.4 From Financial Distress to Bankruptcy . . . . . . . . . . . . . . . . . . . . . 7
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
3 The Models of Financial Distress . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
3.1 Models of Corporate Financial Distress Risk Assessment . . . . . . . . 11
3.2 Beaver’s Univariate Analysis (1966) . . . . . . . . . . . . . . . . . . . . . . . 12
3.3 Altman’s Multivariate Analysis (1968) . . . . . . . . . . . . . . . . . . . . . 14
3.4 The Model of Ohlson (1980) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
3.5 The Model of Zmijewski (1984) . . . . . . . . . . . . . . . . . . . . . . . . . . 21
3.6 The Neural Networks of Etheridge and Sriram (1997) . . . . . . . . . . 22
3.7 Other Models of Financial Distress . . . . . . . . . . . . . . . . . . . . . . . . 24
3.8 Accounting-Based or Market-Based Models? . . . . . . . . . . . . . . . . . 25
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
4 Data Analysis and Empirical Results . . . . . . . . . . . . . . . . . . . . . . . . . 29
4.1 Sampling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
4.2 Variables Description . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
4.3 The Application of Altman’s Model . . . . . . . . . . . . . . . . . . . . . . . 33
4.4 Logistic Regression . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
4.4.1 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
4.4.2 Interpretation of Coefficients . . . . . . . . . . . . . . . . . . . . . . . 37
4.4.3 Logistic Regression Model Fit . . . . . . . . . . . . . . . . . . . . . . 37
vii
viii Contents
4.5 Our Logistic Model for Italian Manufacturing Public Limited

Companies (S.p.A.) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
4.6 Empirical Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
4.6.1 Example on How to Use Our New Model . . . . . . . . . . . . . . 41
Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
5 Conclusions and Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
5.1 Conclusive Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
5.2 Implications for Scholars and Practitioners . . . . . . . . . . . . . . . . . . 45
About the Authors
Matteo Pozzoli, Ph.D., is Associate Professor of Business Administration at the

Department of Law of Parthenope University in Naples (Italy). His research profile
is focused upon corporate reporting, financial distress, and business valuation. He
serves as a staff member of the CNDCEC, the Italian accountants’ professional
body. He is technical advisor at the Corporate Reporting Policy Group of the
Accountancy Europe and member of the Small and Medium Practices Committee
of the International Federation of Accountants. He participated as speaker in several
international and national conferences.
Francesco Paolone holds a degree in Business Administration and Management at

Bocconi University in Milan. He is currently a Post doctoral Researcher of Business
Administration at the Department of Accounting, Management and Economics of
Parthenope University in Naples. His research profiles are mainly focused on
accounting and financial reporting, earnings management, bankruptcy prediction
modeling, corporate governance, and business models innovation. Among his
experiences of studies abroad, there are several periods at Maastricht University
in Netherlands, Georgetown University of Washington DC, Pompeu Fabra Univer-
sity in Barcelona, London School of Business and Finance in London, and Aalborg
University in Denmark. He is author of several scientific contributions in important
international conferences, journals, and books. He is also chartered accountant and
auditor.
ix
Chapter 1
Introduction
During 2007, one of the worst global crises struck the business world; it originated
in the United States, then Europe became involved less than a year later. This global
economic crisis is considered the worst since the Great Depression of the 1920s and
1930s.
Even though this period of crisis has been highly frustrating for many business
investors, owners, lenders and so on, it has however proven to be an excellent
opportunity for Accounting and Finance students, researchers and/or practitioners
from an educational perspective.
It is from this perspective that we have decided to use research material for this
book which is directly linked to the effects of the global economic crisis.
The social and scientific relevance of this study has been covered in various
forms of theoretical and empirical research. From these reference papers we have
concluded that there is no straightforward method to measure or predict financial
distress or the chances of it occurring within Italian manufacturing Public Limited
Companies called Societa per Azioni or S.p.A.
We do notice, however, that there is a great number of research papers regarding
the matter, most of which employ the same underlying variables within their
models.
Pindado et al. (2008) introduced an advanced statistical model to predict finan-
cial distress. They employ a logistic regression model which allows for a dynamic
dimension within said model. The dynamic aspect comes from the fact that they
employ the stock price of the firm before and after it encounters financial distress on
the assumption that the firm which is in financial distress is negatively valued on the
stock exchange therefore experiences a fall in its stock price.
The accuracy of this model comes at the price of requiring one to know a
sufficient degree of math to employ it—a skill which is not always prevalent
among practising research subjects such as business managers and practitioners.
Besides said required math skills, the mentioned model is suited for listed
companies and large datasets specifically.
© The Author(s) 2017 1

M. Pozzoli, F. Paolone, Corporate Financial Distress, SpringerBriefs in Finance,
DOI 10.1007/978-3-319-67355-4_1
2 1 Introduction
On the contrary, Altman (1968 and other versions) elaborated the Z-score model
which is based upon a variety of underlying financial ratios assembled together in a
multiple discriminant analysis model. When the value of the dependent variable
(thus the Z-score) is low, the firm in question is expected to experience financial
distress within the following 2 years—this model is found to be 80% accurate, see
Altman (1968).
Therefore, the higher the value of the dependent variable, the less likely a firm is
to experience financial distress. The value criteria will be further elaborated upon in
our Methodology and Data Analysis chapter (Chap. 4).
The advantage of the Z-score model is that it eliminates the statistical biases
which normally occur when making comparisons between firms—these biases are
usually caused by the great variations in the size and capacity of each firm in terms
of revenues and assets, proxied by total net sales and total assets.
The financial ratios used by Altman are commonly known to experts in account-
ing and finance therefore this model has been widely used by said financial experts
as well as by other related professions for several decades.
In our research, we wish to incorporate several facets of both corporate finance
and entrepreneurship. Not only will we discuss existing models of financial distress
prediction, but also the effects of each financial ratio on the Z-Score applied to
Italian manufacturing industries. The remainder of this thesis is divided as follows:
first we will define what corporate financial distress is. Secondly, we will present a
review of the most used models of distress prediction and provide our empirical
analysis and our own model elaboration. Lastly, we will draw conclusions provid-
ing practical implications, limitations and improvements for future studies.
References
Altman, E. I. (1968). Financial ratios, discriminant analysis and the prediction of corporate
bankruptcy. Journal of Finance, 23, 589–609.
Pindado, J., Rodrigues, L., & de la Torre, C. (2008). Estimating financial distress likelihood.
Journal of Business Research, 61(9), 995–1003.
Chapter 2
Defining Corporate Financial Distress
and Bankruptcy
2.1 Terminology
This text analyzes the probability that a company has to be financial distressed in
the foreseeable future.
The purpose of this chapter is to introduce the examined subject, taking into
consideration the concept of financial distress, as it pertains to the purpose of the
proposed model of prediction. At the same time, this chapter aims to clarify the
meaning of terms applied to entities with financial and/or economic difficulties,
sometimes used synonymously and sometimes used with different meanings. In
doing so, the chapter systemizes the previous contributions coming from literature
and best practice.
The term “financial distress” is used in very diverse contexts in order to identify
failure, default and bankruptcy.
Academics have not taken special care to identify the concepts that are the basis
of predictive models. Scholars have been more focused on the mentioned models
and the classification of components, causes, consequences and “solutions” related
to the afore mentioned phenomena.
2.2 From Decline to Crisis
Generally, it is possible to highlight that a company has an economic cycle life, that
is dynamic and evolutive by nature, and crisis is a physiological circumstance
which can be managed by firms.
However, crisis is usually anticipated by a pre-phase of decline. The proposed
systematization assimilates the concept of crisis to the consequence of a consoli-
dated decline. This phase can be caused by different and heterogenous factors, that
can occur singularly or, more often, combined (Whitaker 1999). As previously

DOI 10.1007/978-3-319-67355-4_2
4 2 Defining Corporate Financial Distress and Bankruptcy
observed, there are many factors determining the decline of a company. Damodaran
(2009) highlighted the factors included in Table 2.1.
As said, corporate crisis is perceived as the deterioration of the decline. Authors
affirm that crisis starts when the business is not able to generate value, thereby
decreasing the entity’s value (Guatri 1992; James 2010).
Even in this circumstance, scholars have been more dedicated to the description
of the factors determining the phenomenon than approaching the concept by a
structural definition. This appears natural also because crisis is an entity specific
element and can assume a diverse outline, when referred to single different firms.
Guatri (1995) highlights, in an evolutionary perspective, that the process moving
from decline to crisis includes four stages: (1) Incubation, evidenced by a decrease
of economic and financial equilibrium; (2) Loss of periods are significant and the
entity’s intrinsic value begins reducing; (3) The mean profitability affects the cash
flows and the reduced credibility implies a higher difficulty of borrowing; (4) Explo-
sion of the crisis that generates internally and externally serious impacts at an
economic, managerial and financial levels.
Table 2.1 Factors that can represent causes of a decline

1. Stagnant or declining revenues: Perhaps the most telling sign of a company in decline is the
inability to increase revenues over extended periods, even when times are good. Flat revenues or
revenues that grow at less than the inflation rate is an indicator of operating weakness. It is even
more telling if these patterns in revenues apply not only to the company being analyzed but to the
overall sector, thus eliminating the explanation that the revenue weakness is due to poor
management (and can thus be fixed by bringing in a new management team).
2. Shrinking or negative margins: The stagnant revenues at declining firms are often accompa-
nied by shrinking operating margins, partly because firms are losing pricing power and partly
because they are dropping prices to keep revenues from falling further. This combination results
in deteriorating or negative operating income at these firms, with occasional spurts in profits
generated by asset sales or one time profits.
3. Asset divestitures: If one of the features of a declining firm is that existing assets are
sometimes worth more to others, who intend to put them to different and better uses, it stands to
reason that asset divestitures will be more frequent at declining firms than at firms earlier in the
life cycle. If the declining firm has substantial debt obligations, the need to divest will become
stronger, driven by the desire to avoid default or to pay down debt.
4. Big payouts—dividends and stock buybacks: Declining firms have few or any growth
investments that generate value, existing assets that may be generating positive cashflows and
asset divestitures that result in cash inflows. If the firm does not have enough debt for distress to
be a concern, it stands to reason that declining firms not only pay out large dividends, sometimes
exceeding their earnings, but also buy back stock.
5. Financial leverage—the downside: If debt is a double-edged sword, declining firms often are
exposed to the wrong edge. With stagnant and declining earnings from existing assets and little
potential for earnings growth, it is not surprising that many declining firms face debt burdens that
are overwhelming. Note that much of this debt was probably acquired when the firm was in a
healthier phase of the life cycle and at terms that cannot be matched today. In addition to
difficulties these firms face in meeting the obligations that they have committed to meet, they
will face additional trouble in refinancing the debt, since lenders will demand more stringent
terms.
Source: our elaboration from Damodaran (2009)
2.3 From Crisis to Financial Distress 5
Some authors distinguish internal crisis from external crisis, whereas the first
one is perceived as a hard decline caused by firm specific factors, with a deviation
from financial performance (Lohe and Calabrò 2017). This differentiation is more
functional to a managerial view, as it aims to identify whether the origin of the crisis
is entity specific or due to exogenous risk issues, related to the market perspective.
Empirical studies confirm that it is not possible to generally attribute more impor-
tance to internal or external factors in the determination of a financial distress
circumstance (Andrade and Kaplan 1998; Maksimovic and Phillips 1998).
An appropriate classification of the reasons that led to the crisis is crucial in
order to comprehend the adequate reaction to the current situation (IDW 2012). The
deeper and longer the crisis, the more timely and wider the reaction. Most of the
time there is no singular cause of the decline and consequently the solution refers to
different areas of intervention. Grant (2010) states that when the decline is
prolonged, the response would likely be both strategic and financial.
In this perspective, practice is progressively more oriented to provide models
able to predict the phenomenon, and not only to declare its existence (CNDCEC
2015).
2.3 From Crisis to Financial Distress
Corporate crisis could lead to a financial and/or economic distress. In general terms,
distress exists when the company’s equilibrium cannot be reached under the current
situation. If other actions are not taken, the firm is naturally destined to cease its
operations. The concept of “economic distress” is not very well developed. The
literature more often refers to this concept, illustrating the aspects related to the
above mentioned economic equilibrium.
The literature has not attributed considerable importance to the definition of
financial distress, whereas it has underlined the significance of predicting this
condition. It seems quite natural, as the concept is often substantiated by juridical
or technical regulation. On this premise, it is possible to propose some consider-
ations upon the concept of financial distress so as to propose a contextualized
definition, which will be applied in the illustrated investigation.
Outecheva (2007) has provided a classification of the various definitions of
financial distress in order to classify the studies concerning the prediction of
financial distress itself. In doing so, the Author identified three different
approaches:
– Event-oriented definitions (Andrade and Kaplan 1998). The approach substan-
tially relates the financial distress to the inability of the company to settle out its
obligations. Authors comprehend financial distress as insolvency, that is, that a
company is financially distressed when it is not capable to satisfy the legitimate
creditors’ obligations (Glen and Singh 2005). In a predictive analysis, financial
distress is the inability to cover current obligations by current monetary assets
(see also technical definitions). In any case, cash flow insolvency is not regarded
as an irreversible failure;
– Process-oriented definitions (Purnanandam 2005). The idea underlining the
approach is that financial distress represents an intermediate phase between
solvency (financial health) and potential bankruptcy (financial illness). This
means that companies need to react, as otherwise the natural conclusion of the
cycle leads to a bankruptcy procedure. This approach is often utilized in studies
related to restructuring operations and actions;
– Technical definitions. The body of literature embracing this orientation defines
financial distress in quantitative terms, adopting financial indicators as symptom
of a significant liquidity emergency (Fedele and Antonucci 2015). This approach
connects the existence of a status of financial distress with the achievement
(or non-achievement) of predetermined ratios. Andrade and Kaplan (1998)
assume that the beginning of financial distress coincides with the first year that
a firm either has an EBITDA lower than interest expense or aims to restructure
its debts. Even if this approach can be criticized as it looks at the past (often
financial statements) and not at the future, it should be noted that a temporarily
analysis can provide the development of the phase and supports a predictive
examination. Most of the time ratios represent symptoms of a financial distress,
and they need to be analyzed.
Even if some studies have provided empirical evidence underlining that there is
no direct relation between economic and financial distress (Senbet and Seward
1995; Kahl 2002), an economic distress can usually lead to a financial distress, if
there is no contribution from stockholders and if there are no reactive actions. On
the other hand, a firm could be financially distressed without being economically
distressed. If a company has a crucial client that cannot settle out its debts, the
company could be financially distressed, even if economically healthy.
Among the last authors, Nigam and Boughanmi (2017) reminds that a company
can be addressed as economically distressed when “the net present worth of the
troubled company’s business as a going concern is less than the value of the assets
broken up and sold separately”. The natural consequence of this state of being is
that the company is no longer viable and must be liquidated.
Apart from the approach utilized, Walter (1957), as many other authors, defines
insolvency as a situation where a firm cannot meet its current obligations. This
concept relates to what has been defined more precisely as “technical insolvency”.
Under this approach, insolvency is substantially a synonym of financial distress
(Altman and Hotchkiss 2010).
Beaver’s definition of failure (Beaver 1966) is substantially coinciding with the
exposed concept of insolvency.
Scholars do not define a univocal relationship between financial distress and
bankruptcy. From another point of view, some authors have examined the potential
connection between financial distress and mean profitability. In some other cases,
the probability of bankruptcy would determine a situation of financial distress
(Hendel 1996).
2.4 From Financial Distress to Bankruptcy 7
2.4 From Financial Distress to Bankruptcy
Bankruptcy is sometimes perceived as a natural or most likely outcome of a

financial distress (Geng et al. 2015). This connection effectively translates the
business economics concept of financial distress into the juridical regime of
bankruptcy.
It is clear that bankruptcy is a disruptive instrument to solve financial distress
circumstance for the business, as operations obviously cease with significant costs
(Laitinen 2013; Markwardt et al. 2016).
Some scholars do not consider bankruptcy to be the best juridical solution of
crisis and that in many cases the mandatory ceasing of operations interrupt com-
panies, that could give back more resources to the community (Ball and Foster
1982). The “reorganization theory” has solid roots in the business economic studies
and aims to safeguard the social function of companies requiring a deep analysis of
the potential alternatives to the company’s death (Altman and Hotchkiss 2006).
Some authors tried to outline a distinction among terms that sometimes are used
in an interchangeable way to bankruptcy such as, failure and default. Failure is a
more economic term, that aims to highlight that the rate of return realized on an
investment is significantly and irreversibly lower than the average profitability on
the sector, or alternatively that characteristic profits are far from the coverage of
related costs.
Some studies conclude that financial indicators and variables are not the most
crucial to predicting the phenomena of bankruptcies (Blanco-Oliver et al. 2015).
Many studies that belong to this body of literature are more inclined to including the
concept of financial distress in the wider field of management and/or financial risks
(Altman et al. 2010).
The above terms of course refer to a relationship with obligations incurred to
third parties. By this premise, it appears clear that the more an entity is indebted, the
higher the probability is that financial difficulties exist. Some scholars relate the
level of indebt to the default or bankruptcy of the company. Some research focuses
on SME credit worthiness, as smaller entities have usually a lower rate of internal
funds (Altman and Sabato 2005).
Going concern is a very well-known principle for accountants and book-keepers,
as well as for auditors (Fremgen 1968). The idea of going concern is included in the
International Accounting Standard 1 (IAS 1), Presentation of Financial Statements,
published by the International Accounting Standards Board, where it is stated that:
“[a]n entity shall prepare financial statements on a going concern basis unless
management either intends to liquidate the entity or to cease trading, or has no
realistic alternative but to do so. When management is aware, in making its
assessment, of material uncertainties related to events or conditions that may cast
significant doubt upon the entity’s ability to continue as a going concern, the entity
shall disclose those uncertainties. When an entity does not prepare financial state-
ments on a going concern basis, it shall disclose that fact, together with the basis on
which it prepared the financial statements and the reason why the entity is not
regarded as a going concern” (IASB, IAS 1, par.25).
By reading the above reported accounting standard, it is clear that going concern
is an accounting assumption that affects the whole accounting process. The
GAAP’s assumption usually focuses on the firm’s capability of continuing to
operate in the foreseeable future, that is in the case of IASB’s equal to 12 months.
Going concern has to be monitored by the company and verified by external
auditors. Professional standards have identified some consolidated heterogenous
indicators which can represent a symptom of lack of going concern. It is not
automatic that the going concern assumption does not exist anymore, when one
or more indicator appear.
Specifically, ISA 570, Going concern, enacted by the International Auditing and
Assurance Standards Board, presents a set of indicators very common in auditing
(see Table 2.2).
Going concern is a potential consequence of distress. How stated, distress takes
into account the foreseeable future firm’s capability to produce profits. Judgment on
the existence (or lack) of going concern requires a professional opinion. In the case
of going concern, the company should, however, address circumstances that are
more “tangible” than a prediction.
Table 2.2 Events or conditions that may cast significant doubt on the entity’s ability to continue
as a going concern
Financial Operating
– Net liability or net current liability position – Management intentions to liquidate the
– Fixed-term borrowings approaching maturity entity or to cease operations
without realistic prospects of renewal or – Loss of key management without replace-
repayment; or excessive reliance on short-term ment
borrowings to finance long-term assets – Loss of a major market, key customer(s),
– Indications of withdrawal of financial support franchise, license, or principal supplier(s)
by creditors – Labor difficulties
– Negative operating cash flows indicated by – Shortages of important supplies
historical or prospective financial statements – Emergence of a highly successful competitor
– Adverse key financial ratios Other
– Substantial operating losses or significant – Non-compliance with capital or other statu-
deterioration in the value of assets used to tory or regulatory requirements, such as sol-
generate cash flows vency or liquidity requirements for financial
– Arrears or discontinuance of dividends institutions
– Inability to pay creditors on due dates – Pending legal or regulatory proceedings
– Inability to comply with the terms of loan against the entity that may, if successful, result
agreements in claims that the entity is unlikely to be able to
– Change from credit to cash-on-delivery satisfy
transactions with suppliers – Changes in law or regulation or government
– Inability to obtain financing for essential new policy expected to adversely affect the entity
product development or other essential – Uninsured or underinsured catastrophes
investments when they occur
Source: IIASB, ISA 570 (revised), A3
References 9
References
Altman, E. I., & Hotchkiss, E. (2006). Corporate financial distress and bankruptcy: Predict and
avoid bankruptcy, analyze and invest in distressed debt. Hoboken, NJ: John Wiley & Sons.
Altman, E. I., & Hotchkiss, E. (2010). Corporate financial distress and bankruptcy: Predict and
avoid bankruptcy, analyze and invest in distressed debt (Vol. 289). Hoboken, NJ: John Wiley
& Sons.
Altman, E. I., & Sabato, G. (2005). Effects of the new Basel capital accord on bank capital
requirements for SMEs. Journal of Financial Services Research, 28(1), 15–42.
Altman, E. I., Sabato, G., & Wilson, N. (2010). The value of non-financial information in small
and medium-sized enterprise risk management. The Journal of Credit Risk, 6(2), 95.
Andrade, G., & Kaplan, S. N. (1998). How costly is financial (not economic) distress? Evidence
from highly leveraged transactions that became distressed. The Journal of Finance, 53(5),
1443–1493.
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Chapter 3
The Models of Financial Distress
3.1 Models of Corporate Financial Distress Risk

Assessment
Corporate financial distress risk assessment has been a part of economic and
financial literature for a long time. Many researchers and practitioners have widely
investigated this issue during the recent decades and have developed new methods
to predict financial distress and bankruptcy.
The techniques of corporate distress prediction have been dominated by static
single-period models which seek to identify unique characteristics that discriminate
between distressed and non-distressed firms. Beaver (1966), Altman (1968), Ohlson
(1980) and many others provide an extensive research for future contribution in the
years after.
The detection of operating and financial difficulties of a company is a subject
which has been particularly amenable to analysis with financial ratios. Prior to the
development of quantitative measures of company performance, agencies were
established to supply a qualitative type of information assessing the credit-
worthiness of particular merchants. Formal aggregate studies concerned with por-
tents of business failure were evident in the 1930s. The first classic work in the area
of ratio analysis and bankruptcy classification was performed by Beaver (1966). In
1968, Altman employed a multiple discriminant analysis (MDA) wherein a set of
financial and economic ratios were investigated. The result of his study was a
bankruptcy prediction model based on accounting data. More recently, academics
developed various bankruptcy prediction models. In the following paragraphs we
analyze all relevant models of bankruptcy prediction which are widely used in
empirical studies; in particular, we focus on Beaver (1966), Altman (1968), Ohlson
(1980) and Zmijewski (1984).

DOI 10.1007/978-3-319-67355-4_3
12 3 The Models of Financial Distress
3.2 Beaver’s Univariate Analysis (1966)
In 1966, William H. Beaver defines “failure” as the inability of a firm to pay its
financial obligations as they mature. He applies a univariate statistical analysis for
the prediction of corporate failure and compares the means of failed firms with
those of non-distressed companies and shows that failed firms have lower financial
ratios. Even 5 years prior to bankruptcy, the financial ratios of the failed firms are
substantially lower than those of comparably sound enterprises. The ratios become
significantly worse as default approaches.
He identifies three criteria for the selection of ratios in order to analyze a group
of failed firms within 5 years prior to default:
– Popularity/frequency of the appearance of the ratios in the literature.
– Performance of the ratios in previous studies.
– Use of ratios within the framework of a “cash-flow” theory.
He groups 79 failed US firms including bankruptcies, bond defaults, overdrawn
bank accounts, and firms that omitted payment of preferred stock dividends. The
failed firms were identified in Moody’s Industrial Manual during the time period of
1954–1964.
The majority of the 79 Failed companies belonged to the manufacturing sector.
They present asset sizes ranging from $0.6 million to $45 million with an average of
around $6 million. A set of non-failed firms similar in asset size were also selected
to compare and to discriminate against the failed firms.
After obtaining the financial statements of both sets for up to 5 years prior to
bankruptcy, Beaver examined 30 ratios between the groups. These 30 ratios were
selected based on performance from previous studies and defined in terms of cash
flow (see Table 3.1).
Financial data were analyzed by comparison of mean values and a dichotomous
classification test. In comparing the mean values, Beaver concluded that with a
degree of regularity the data demonstrated differences in the mean for at least
5 years prior to failure, with the differences increasing as the years of failure
approached. This shows a significant difference in the ratios of failed firms and
non-failed firms.
The dichotomous classification test makes a prediction of whether a firm is either
failed or non-failed. As per the test, each ratio is arranged in ascending order and for a
given ratio an optimal cut-off point is found. This cut-off point is where the percent of
incorrect predictions is minimized. Thus, if a firm’s ratio is below the cut-off point,
the firm is classified as failed and if it is above it, it will be classified as non-failed.
Using this method, Beaver performs a dichotomous classification test of the
predictive ability of the chosen accounting measures and identifies the three most
powerful ratios: cash flow/total assets, cash flow/total debt, and net income/total
debt. The cut-off points were then used to classify firms in a holdout sample (which
is not to be confused with the original paired sample of non-failed firms).
The results of the test for the fraction of the sample that is misclassified is shown
in Table 3.2.
3.2 Beaver’s Univariate Analysis (1966) 13
Table 3.1 The ratios of Beaver (1966)

Group I (Cash-flow ratios) Group V (Liquid-asset to current debt ratios)
1. Cash flow to sales 1. Cash to current liabilities
2. Cash flow to total assets 2. Quick assets to current liabilities
3. Cash flow to net worth 3. Current ratio (current assets to current liabilities)
4. Cash flow to total debt Group VI (Turnover ratios)
Group II (Net-income ratios) 1. Cash to sales
1. Net income to sales 2. Accounts receivable to sales
2. Net income to total assets 3. Inventory to sales
3. Net income to net worth 4. Quick assets to sales
4. Net income to total debt 5. Current assets to sales
Gruop III (Debt to total-asset ratios) 6. Working capital to sales
1. Current liabilities to total assets 7. Net worth to sales
2. Long-term liabilities to total assets 8. Total assets to sales
3. Current plus long-term liabilities to 9. Cash interval (cash to fund expenditures for opera-
total assets tions)
4. Current plus long-term plus pre- 10. Defensive interval (defensive assets to fund expen-
ferred stock to total assets ditures for operations)
Group IV (Liquid-asset to total-asset 11. No-credit interval (defensive assets minus current
ratios) liabilities to fund expenditures for operations)
1. Cash to total assets
2. Quick assets to total assets
3. Current assets to total assets
4. Working capital to total assets
There are two types of errors which can occur in classification models. Type I
error represents the misclassification of a financially distressed firm. Type II error
represents the misclassification of a sound company. The ratio of the cash flow to
total debt misclassified only 13% of the sample firms 1 year before bankruptcy and
22% of the sample firms 5 years before bankruptcy.
Within the scope of the cash-flow model the firm is viewed “as a reservoir of
liquid assets which is supplied by inflows and drained by outflows”. Beaver does
not define distress risk explicitly. As long as the reservoir is full, the company
remains solvent.
The greater the probability that the reservoir will be exhausted, the higher the
risk of default is. Four propositions based on logical rather than theoretical knowl-
edge are derived from this cash-flow concept:
(a) The larger the amount of liquid assets and
(b) The larger the amount of cash flows from operations
the smaller the risk of default
(c) The larger the amount of total debt held and
(d) The larger the cash outflows from operations
the greater the risk of default.
Beaver concluded: “the evidence indicates that the ratio analysis can be useful in
the prediction of failure for at least 5 years before failure”.
Despite Beaver’s predictors performing well in the short term, the univariate
analysis has a number of limitations.
At first, single ratios calculated by Beaver do not capture time variation of
financial ratios. This means that accounting ratios have their predictive ability
Table 3.2 Misclassified test Fraction misclassified using dichotomous test

of Beaver (1966)
Years before failure
Ratio 1 2 3 4 5
Cash Flow 0.10 0.20 0.24 0.28 0.28
Total Assets
(0.10) (0.17) (0.20) (0.26) (0.25)
Cash Flow 0.13 0.21 0.23 0.24 0.22
Total Debt
(0.10) (0.18) (0.21) (0.24) (0.22)
Net Income 0.15 0.20 0.22 0.26 0.32
Total Debt
(0.08) (0.16) (0.20) (0.26) (0.26)
Source: Beaver Study (1966, Table A-4). The fractions in paren-
thesis ate the results from the original sample of the first test. The
top fraction are the results from the holdout sample of the second
test
one at a time, and it is impossible to analyze, for instance, rates of change in ratios
over time.
Second, single ratios may give inconsistent results if different ratio classifica-
tions are applied to the same firm.
Third, many accounting variables are highly correlated, so that the interpretation
of a single ratio in isolation may be incorrect. The single ratio is not able to capture
multidimensional interrelationships within the firm.
Finally, since the probability of failure for a sample is not the same as for the
population, specific values of the cutoff points obtained for the sample will not be
valid for the population. In other words, univariate techniques as analytical tools of
distress risk assessment are imperfect and need further development.
Seeking to eliminate the weaknesses in Beaver’s model and to develop its
successful extension, Altman (2005) formulated the following questions:
(a) Which ratios are the most important in detecting bankruptcy potential?
(b) What weights should be attached to those selected ratios?
(c) How should the weights be objectively established?
A careful consideration of the weaknesses of Beaver’s univariate model has led
to the development of the Z-Score, which is based upon the multiple discriminant
analysis and is the subject of the discussion in the next paragraph.
3.3 Altman’s Multivariate Analysis (1968)
Following the model of Beaver, many researchers investigated multivariate tech-

niques of selecting a set of financial indicators which best discriminates between
failed and non-failed firms.
The most notable work still used among scholars and practitioners involved
Edward I. Altman in 1968. In this study, bankruptcy referred to those firms that are
legally bankrupt and either placed in receivership or have been granted the right to
reorganize. This differs from the broader definition that Beaver used.
3.3 Altman’s Multivariate Analysis (1968) 15
He developed a statistical method called multiple discriminant analysis (MDA)

deriving from a linear combination of financial ratios that best discriminate between
two groups of firms. In this line of research, the groups consist of the qualitative
classification of bankrupt or non-bankrupt and the features are selected financial
ratios. The coefficients of ratios are the appropriate weights that will separate the
financial ratio values between the two groups as much as possible, while minimiz-
ing the statistical distance of each ratio from its own group mean. The discriminant
coefficients can then be applied directly to the financial ratios within the discrim-
inant function to produce an overall score (the so-called Z-Score) that can be used
to classify the firm into one of the aforementioned groups.
The sample of firms used for analysis consisted of a paired set of bankrupt and
non-bankrupt firms. With 1946–1965 as the time period analysis, the pairs of
bankrupt and non-bankrupt were chosen to be reasonably similar in size and industry
classification.
Altman’s discriminant model used the financial model of 33 firms declaring
bankruptcy during the period of 1946–1965 and paired with a stratified sample of
33 firms not declaring bankruptcy. The study used only manufacturing corporations
ranging in size from $0.7 million to $25.9 million. In this case, the use of multiple
discriminant analysis (MDA) is appropriate statistical technique in which only two
groups (bankrupt and non-bankrupt firms) are classified.
Altman challenges the quality of the univariate ratio analysis as an analytical
technique. He applies multivariate discriminant analysis to derive a linear combi-
nation of the ratios which “best” discriminate between financially distressed and
non-distressed groups. Altman uses a sample of 33 bankruptcies filed between 1946
and 1965 and matches them with 33 non-distressed firms from the same industry
and of similar size. All companies operated in the manufacturing industry; small
firms with assets less than $1 million are deleted from the sample. Similarly to
Beaver, he selects 22 financial ratios MDA, takes data from each distinct group and
maximizes the statistical distance between the two groups’ data sets, relative to the
difference in the data within the groups. Not all ratios for bankrupt firms are equal
and neither are all the ratios pertinent to the non-bankrupt firms. Therefore there is a
variation in the ratio within each group. But MDA assumes that the ratios between
the bankrupt and the non-bankrupt groups differ systematically. Given such a
difference, MDA attempts to maximize the difference between groups relative to
the differences within the group. The MDA generates a set of discriminant coeffi-
cients for each variable (ratios). When these coefficients are applied to the actual
firms’ ratios, a score is produced as a basis of classification in one of the mutually
exclusive groupings, either bankrupt or non-bankrupt.
The form of the discriminant function is:
Z ¼ A 1 X 1 þ A2 X 2 þ þ An X n
Where:
Z is the value used to classify or predict the firm into one of the groupings.
A1, A2, . . ., An are the discriminant coefficients.
X1, X2, . . ., Xn are the set of predictor variables (ratios).

MDA has the advantage of considering an entire profile characteristic common
within the group of firms, while a univariate study can only analyze the ratios one at
a time (Tables 3.3 and 3.4).
From the list of 22 ratios, Altman selected the following ratios for the final
discriminant function as shown:
Z-Score ¼ 0:012X1 þ 0:014X2 þ 0:033X3 þ 0:006X4 þ 0:999X5
where:
X1 ¼ working capital/total assets.
X2 ¼ retained earnings/total assets.
X3 ¼ earnings before interests and taxes/total assets.
X4 ¼ market value of equity/book value of total debt.
X5 ¼ sales/total assets.
Altman’s function was first tested with the initial 66 sample firms.
The discriminant-ratio model proved to be extremely accurate in predicting
bankruptcy correctly in 94% of the initial sample with 95% of all firms in the
bankrupt and non-bankrupt groups assigned to their actual group classification.
Type I error (classifying a bankrupt firm as non-bankrupt) was only 6%, while Type
II error (classifying non-bankrupt as bankrupt) was even lower at 3%. For 2 years
prior to bankruptcy, a reduction in accuracy of 83% was noted overall.
This evidence suggests that bankruptcy can be predicted at least 2 years prior to
the event. A second test was conducted using a sample of 25 bankrupt firms and
correctly classified 24 (96%).
Altman also tested a new sample of 66 non-bankrupt firms in manufacturing
which suffered losses and net income. The discriminant model correctly classified
79% of the sample firms (Table 3.5).
Altman further concluded that firms with the Z scores greater than 2.99 are
classified as non-bankrupt and those less than 1.81 are classified as bankrupt. The
firms that score between 1.81 and 2.99 are in the “zone of ignorance” due to the
possibility of error classifications.
A limitation of Altman’s model is that the firms analyzed were all publicly held
manufacturing corporations for which comprehensive financial data were obtain-
able, including market price quotations. Therefore, an area for future research
would be to extend the analysis to relatively smaller asset-sized firms and
unincorporated entities where the incidence of business failure is greater than
with larger corporations.
The Z-Score presents several practical and theoretical applications of the model
such as business credit evaluation, internal control procedures, and investment
guidelines. The assumption that signs of deterioration, detected by a ratio index,
can be observed clearly enough to take profitable action is inherent in these
applications. A potential theoretical area of importance lies in the conceptualization
of efficient portfolio selection. One of the current limitations in this area is in a
Table 3.3 Average ratios of Altman (1968, p. 605)
Average ratios bankrupt group prior to failure—Original sample
Fifth Year Fourth Year Third Year Second Year First Year
Ratio Ratio Changea Ratio Changea Ratio Changea Ratio Changea Ratio Changea
Working capital/total 19.5 23.2 +3.6 17.6 5.6 1.6 16.0b (6.1) 7.7 Financial ratios and dis-
assets (%) criminant analysis
(X1)
Retained earnings/total 4.0 (0.8) 4.8 (7.0) 6.2 (30.1) 23.1 (62.6) 32.5b
assets (%)
(X2)
EBIT/total assets (%) 7.2 4.0 3.2 (5.8) 9.8 (20.7) 14.9b (31.8) 11.1
3.3 Altman’s Multivariate Analysis (1968)
(X3)
Market value equity/ 180.0 147.6 32.4 143.2 4.4 74.2 69.0b 40.1 34.1
total debt (%)
(X4)
Sales/total assets (%) 200.0 200.0 0.0 166.0 34.0b 150.0 16.0 150.0 0.0
(X5)
Current ratio (%) 180.0 187.0 +7.0 162.0 25.0 131.0 31.0b 133.0 +2.0
Years of negative 0.8 0.9 +0.1 1.2 +0.3 2.0 +0.8b 2.5 +0.5
profits (years)
Total debt/total assets 54.2 60.9 +6.7 61.2 +0.3 77.0 +15.8 96.4 +19.4b
(%)
Net worth/total debt 123.2 75.2 28.0 112.6 +17.4 70.5 42.1 49.4 21.1
(%)
a
Change from previous year
b
Largest yearly change in the ratio
17
Table 3.4 Significant test of Altman (1968, p. 596)

Variable means and test of significance
Variable Bankrupt group mean Non bankrupt group mean F Ratio
n ¼ 33 (%) n ¼ 33 (%)
X1 6.1 41.4 32.60*
X2 62.6 35.5 58.86*
X3 31.8 15.3 26.56*
X4 40.1 247.7 33.26*
X5 150.0 190.0 2.84
*Significant at the 0.001 level
F1,60 (0.001) ¼ 12.00
F1,60 (0.01) ¼ 7.00
F1,60 (0.05) ¼ 4.00
Table 3.5 Accuracy prediction of Altman (1968, p. 604)

Five year predictive accuracy of the MDA model (initial sample)
Year prior to bankruptcy Hits Misses Per cent correct
First n ¼ 33 31 2 95
Second n ¼ 32 23 9 72
Third n ¼ 29 14 15 48
Fourth n ¼ 28 8 20 29
Fifth n ¼ 25 9 16 36
realistic presentation of those securities and the types of investment policies which
are necessary to balance the portfolio and avoid downside risk. The ideal approach
is to include those securities possessing negative co-variance with other securities
in the portfolio. However, these securities are difficult to locate, even impossible.
The problem becomes somewhat more solvable if a method is introduced which
rejects securities with high downside risk or includes them in a short-selling
context. The discriminant-ratio model appears to have the potential to ease this
problem. Further investigation, however, is required on this subject.
The Z-Score model has been modified several times over the past years by
Altman (1984, 1993, 2005); Altman and Hotchkiss (2006) and Altman et al.
(1995, 1977, 2013) who has constantly revised the parameters and adapted the
indices to different populations of companies other than American manufacturers
quoted on the Stock Market. The Z-Score (Altman 1984) is an adaptation for private
companies.
3.4 The Model of Ohlson (1980)
Ohlson (1980) criticizes the restrictive assumptions of multiple discriminant anal-

ysis and the output of this technique—a single dichotomous score which, in fact,
says nothing about the probability of default. In order to mitigate these problems, he
3.4 The Model of Ohlson (1980) 19
introduces an alternative econometric technique based on the logistic transforma-

tions (Logit model). Similar to the discriminant analysis, this technique weighs the
independent variables and assigns a score.
The discriminant function is:
Y ¼ B0 þ B 1 X 1 þ B2 X 2 þ þ B9 X 9
Failing: is 0 for failed firm-years and 1 for other firm-years.

The independent variables are described as follows:
X1: Log (Total assets/GNP price-level index)
X2: Total Liabilities divided by Total Assets
X3: Working Capital divided by Total Assets
X4: Current Liabilities divided by Current Assets
X5: 1 if Total Liabilities exceed Total Assets, 0 otherwise
X6: Net Income divided by Total Assets
X7: Funds provided by operations (income from operations after depreciation)
divided by Total Liabilities
X8: 1 if Net Income was negative for the last 2 years, 0 otherwise
X9: (NIt NIt1) divided by (|NIt| + |NIt1|)
Where:
NIt is Net Income for the most recent period. The denominator acts as a level
indicator. The variable is intended to measure the relative change in Net Income.
However, unlike discriminant analysis, this model estimates the probabilities of
default for each company in a sample. The logit approach of Ohlson incorporates
non-linear effects and uses the logistic cumulative distribution function to maxi-
mize the joint probability of default for the distressed firms and the probability of
non-failure for the healthy companies in the sample:
ðzÞ ¼ 11 þ eðzÞ ¼ 11 þ eðw0 þw1 x1 þþwn xn Þ
Where:
z is a linear combination of the independent variables
w0 is a constant
wi represents coefficients
xi is independent variables.
The method of maximum likelihood is applied to estimate the coefficients.
In addition, Ohlson uses an improved database obtained from annual financial
reports which contains information about the date of release and allows comparison
as to whether the company defaulted prior to or after the date of release. The thin
time issue is a very important innovation in Ohlson’s analysis. The final sample
contains 105 industrial firms which went bankrupt in the period between 1970
and 1976.
Ohlson chooses his default predictors based on the frequency of appearance in

the literature and identifies four basic factors which are statistically significant in
assessing the probability of default within 1 year:
– The size of the company.
– A measure(s) of the financial structure.
– A measure(s) of performance.
– A measure(s) of current liquidity.
Finally, for the estimation of the coefficients and the calculation of the O-Score
predicting default within 1 year, nine independent variables are employed, two of
which are dummies. The use of qualitative variables is another advantage of the
logit model compared to the discriminant analysis. The latter is limited to the
interpretation of quantitative ratios.
The overall O-Score function is defined as:
O-Score ¼ 1:32 0:407 LogðTotal Assets=GNP price level indexÞ
þ6:03ðTotal Liabilities=Total AssetsÞ
1:43ðWorking Capital=Total AssetsÞ
þ0:076ðCurrent Liabilities=Tota AssetsÞ
1:72ð1 if Total Liabilities > Total Assets; else 0Þ
2:37ðNet Income=Total AssetsÞ
1:83ðFunds from operation=Total LiabilitiesÞ
þ0:285ð1 if a Net Loss for the last two years; 0 otherwiseÞ
0:521ðNet Incomet Net Incomet1 =jNet Incomet
þNet incomet1 jÞ
The higher the O-Score, the higher the risk of default.

Ohlson finds that a cutoff of 0.038 minimizes the sum of Type I and Type II
estimation errors in his sample. A type I error occurs if the O-Score is less than the
cutoff point but the firm is bankrupt. If the O-Score is greater than the cutoff point
but the firm is non-bankrupt, this is a Type II error. Ohlson reports that the size of
the company appears to be the most significant predictor of financial distress.
However, the comparison of the predictive accuracy of the logit model with
multivariate discriminant analysis by means of the same set of variables and the
same sample had as a result a very modest improvement by O-Score in comparison
to the previous models.
To sum it up, Ohlson introduced a new econometric technique to forecast the
probability of default. However, as noticed by Keasey and Watson (1991), “logit
analysis offers as much as any other technique to the user”.
The accuracy of the predicting functions crucially depends not on the method
chosen for the analysis, but on the structure and availability of data and the
assumptions made concerning costs of misclassification. In this sense, the logit
model has many applications for researchers. However, it does not automatically
guarantee a substantial improvement in accuracy in predicting financial distress.
The logit model of Ohlson is criticized because “all parameters are fixed and the
error structure is treated as white noise, with little behavioral definition” (Hensher
3.5 The Model of Zmijewski (1984) 21
et al. 2007, p. 243). Hensher et al. (2007) propose a mixed logit model instead of a
simple logit model. This mixed logit model recognizes “the substantial amount of
heterogeneity that can exist across and within all firms in terms of the role that
attributes play in influencing an outcome domain” (Hensher et al. 2007, p. 243).
Grice and Dugan (2003) indicated that the accuracy of the models of Ohlson (1980)
increase when the coefficients are re-estimated. This finding is the result of another
research design proposed by Grice and Dugan (2003).
3.5 The Model of Zmijewski (1984)
The Zmijewski Score is a bankruptcy model used to predict a firm’s bankruptcy in

2 years. The ratio used in the Zmijewski score were determined by probit analysis.
In this case, scores greater than X represent a higher probability of default.
Zmijewski (1984) mentions that there are two problems with how other bank-
ruptcy predicting models are constructed. The first problem arises in the way some
researchers match the samples of non-bankrupt and bankrupt firms. When bankrupt
firms are chosen first, and then a match is chosen based on some criteria, the sample
is not a random sample anymore. The second problem is that firms with incomplete
data are often removed from the dataset, which can only be done if the subsample of
firms with incomplete data is a random sample of the total sample. Zmijewski
(1984) tries different sample sizes, and the sample with 40 bankrupt companies and
800 non-bankrupt is used.
The Zmijewski model (1984) based on the 40 bankrupt and 800 non-bankrupt
firms is the most commonly used model by accounting researchers (Grice and
Dugan 2003). He used the probit technique to construct his bankruptcy prediction
model and found an accuracy rate for the estimation sample of 99%. He did not
report the accuracy rate for the hold-out sample.
The population of firms consists of all firms listed on the American and
New York Stock Exchanges during the period 1972 through 1978 with the excep-
tion of finance, service and public administration industries.
He identified bankrupt firms if they filed a bankruptcy petition during this period
and non-bankrupt if they did not. The final estimation sample contained 40 bankrupt
and 800 non-bankrupt firms, and a hold-out sample containing 41 bankrupt and
800 non-bankrupt firms. The constructed probit function with the variables and
estimated coefficients is shown as follows:
Zmijewski Score ¼ 4:3 4:5X 1 þ5:7X 2 þ0:004X 3
where:
X1: Net Income divided by Total Assets
X2: Total Liabilities divided by Total Assets
X3: Current Assets divided by Current Liabilities
A firm with a probability greater than 0.5 is classified as bankrupt, and a firm with
a probability smaller than 0.5 is classified as non-bankrupt. The overall out-of-sample
accuracy rate of Zmijewski’s model is 95.29%, but it is important to note that none of
the bankrupt firms are predicted to go bankrupt in this classification, and in 99.39% of
all non-bankrupt firms the model classified the firms as non-bankrupt. In fact, the
cut-off point here is not corrected for the different numbers of bankrupt and
non-bankrupt firms.
According to Grice and Dugan (2003), one of the main limitations of the
Zmijewski model is that the ratios were not selected on a theoretical basis, but
rather on the basis of their performance in prior studies. In fact, the models of
Altman (1968) and Ohlson (1980) have the same limitation. Furthermore, it is
criticized because the original study used “financial ratios that discriminated among
industrial firms” (Grice and Dugan 2003, p. 85).
The probit model of Zmijewski is preferred over MDA because the probit
function maps the value to a probability bounded between 0 and 1; this value is
easy to interpret. This is also the case for the logit model.
Another criticism made by Platt and Platt (2002, p.186) was: “Because
Zmijewski ran only one regression for each sample size, he could not test the
individual estimated coefficients for bias against the population parameter, a more
direct test of bias”. By contrast, Platt and Platt (2002) used more standard tests of
bias, comparing the mean estimated coefficient to the population parameter.
3.6 The Neural Networks of Etheridge and Sriram (1997)
The univariate analysis, the multivariate discriminant analysis and the logit and
probit analysis may suffer from several limitations, such as multicollinearity,
probability distribution and non-linear relationship.
If the data used or models developed do not follow the above assumptions, the
results may be questionable. For this reason, many researchers have found that the
neural networks are an alternatively useful methodology in which the above
limitations can be ignored completely.
Etheridge and Sriram (1997) analyzed the performance of the neural networks
with the aim of predicting the financial distress of firms by comparing it with the
multivariate and logit/probit statistical models.
They found that neural networks outperform multivariate analysis with the
consideration of the small relative error costs. Furthermore, Zurada et al. (1998)
evidenced that the neural networks can better describe the complex relationships
among variables than the logistic regression analysis can. Considering only the
accuracy of prediction, they found that neural networks should be specifically
applied for the more complex dependent variables (i.e. the multi-state variables,
while a logistic model should be used for binary dependent variables).
3.6 The Neural Networks of Etheridge and Sriram (1997) 23
Table 3.6 Resume of the main models of Bankruptcy prediction

Altman Ohlson Zmijewski
Beaver (1966) (1968) (1980) (1984)
Statistical Univariate MDA Logit Probit
technique
Sample size 79 bankrupt N ¼ 66 N ¼ 2163 N ¼ 840
33 bankrupt 105 bankrupt 40 bankrupt
33 2058 800
non-bankrupt non-bankrupt non-bankrupt
Independent 15 of Net Income ratios EBIT/TA Net Income/ Net Income/
variables of (4) Turn-over ratios (11) Sales/TA TA TA
profitability Change in
Net Income
Independent 11 of Cash Flow ratios (4), Working Working CA/CL
variables of Liquid-Asset to Total Asset Capital/TA Capital/TA
liquidity ratios (4) and Liquid-Asset to CL/CA
Current Debt ratios (3) Funds*/TL
INTWO
Independent 4 of Debt divided by TA Retained TL/TA Total Debt/
variables Earnings/TA OENEG TA
leverage MV of
Equity/BV of
Debt
Other inde- Size ¼ Log
pendent (TA/GNP
variables price-level
index)
TA Total assets, EBIT Earnings before interests and taxes, MV market value, BV book value, CA
current assets, CL current liabilities, Funds ¼ Funds provided by operations, OENEG ¼ variable
that takes value of 1 if Total Liabilities > Total Assets, 0 otherwise; INTWO ¼ dummy variable
that takes value of 1 if Net Income was negative in the last 2 years, 0 otherwise
In addition, Eftekhar et al. (2005) confirmed that the neural networks are
appropriate when applied to a model with non-linear complex interactions. It is
found that neural networks methodology does not provide superior results to those
of the discriminant analysis and logistic models (Charitou et al. 2004; Coats and
Fant 1993).
Although the neural networks can be considered a way of overcoming the
limitations of multivariate and logistic regressions providing a higher accurate
rate of classification, it is not applicable when the objective of the study is to
achieve the significance of independent variables (Etheridge and Sriram 1997).
It is more difficult to interpret the meaning of independent variables including
the neural network model compared to the logistic regression model (Eftekhar et al.
2005). Hence, it is more useful to apply the neural network analysis if researchers
aim to develop an effective early warning model used to explain non-linear
complex relationships among the variables (Tables 3.6 and 3.7).
Table 3.7 Statistical techniques in corporate financial distress studies

Methodology Characteristics Literature
Univariate – Examine the predictive ability of financial ratios to Beaver (1966)
analysis be tested one ratio at a time
– Show the relationship between two variables
– It has a limitation since it cannot examine many
ratios at the same time
Multivariate dis- – Examine two or more different variables simulta- Altman (1968)
criminant analysis neously. Assume multivariate normally distribution
and variance-covariance metrics
– Prevents the use of dummy variables
– Does not provide probability of firms’ financial
distress and significance of predictors
Logit and probit – Design for the binary dependent variable Ohlson (1980),
analysis – Help to develop the nonlinear regression model Zmijewski (1984)
with assumption of cumulative distribution function
– Provide probability of firms’ financial distress and
significance of predictors
– Does not require assumption on the distribution of
predictors
Neural network – Help to explain a very complex relationship Etheridge and
– Does not require any distribution assumption Sriram (1997)
– Does not provide significance of individual
variables
3.7 Other Models of Financial Distress
Other models of bankruptcy predictions with the use of financial ratios including
the following:
(a) Deakin (1972). He used financial accounting data and multivariate discriminant
analysis on bankrupt and non-bankrupt companies. He concluded that most
ratios showed discriminatory ability. The test achieved bankruptcy classifica-
tion rate of 97% 1 year prior and over 70% for several previous years.
(b) Edmister (1972). He tested the usefulness of financial ratios for predicting small
business failures by developing a discriminant function composed of seven
variables from nineteen initial ratios using stepwise MDA1. A high accuracy
classification rate of 93% was noted. He further concluded that for small firms
at least three consecutive financial statements be available for analysis. While
large firms could be analyzed with a single year financial statement. This is
evident from the Beaver and Altman studies.
(c) Altman et al. (1977). They introduce the new Zeta bankruptcy model using
seven variables. These seven variables out of 27 analyzed are:
– Return on assets (EBIT/Total Assets)
– Stability of earnings (which is the standard error of estimate of a 10-year trend
on EBIT/total assets)
3.8 Accounting-Based or Market-Based Models? 25
– Debt service (which is measured by taking the log 10 of familiar interest

coverage ratio, i.e. EBIT/Total interest payments)
– Cumulative profitability (retained earnings/total assets)
– Liquidity (current assets/current liability)
– Capitalization (Market value of equity/Total capital)
– Size which is measured by the firms’ total assets.
They used large firms (greater than $20 million in assets) in manufacturing
and retailing. MDA technique was used to find both a linear and a quadratic
model structure for bankruptcy classification. Their results indicated that the
linear model outperformed the quadratic structure in the tests of model
validity. Classification accuracy ranges from 96% (93% for holdout sample)
for 1 year prior to 70% 5 years prior for the linear model.
(d) Moyer (1977). He re-examined Altman’s 1968 bankruptcy model and used a
stepwise MDA method that developed a model which eliminated the X4
(market value of equity/book value of total debt) and X5 (sales/total assets)
variables. Both the re-estimate and alternative had high prediction rates of
about 90%. The re-estimate function was slightly better.
(e) Holmen (1988). He made comparison of Beaver’s and Altman’s models for
bankruptcies occurring between 1977 and 1984. The majority of these firms
were in manufacturing and only one construction firm out of a total of 84. The
ratio of cash flow/total debt was used with two cut-off points, 0.3 and 0.7, as
determined by Beaver to be the single best predictor of bankruptcy. Based on
his analysis, Beaver’s simple cash flow to total debt ratio predicted bankruptcy
with fewer errors than Altman’s five ratio Z-score.
The above studies are only a fraction of the total amount of bankruptcy literature.
In general, one may conclude that financial ratios can predict bankruptcy at least
2 years prior to the event.
3.8 Accounting-Based or Market-Based Models?
The Accounting-based models investigate the importance of the use of information

contained in the financial statements of a company to provide an accurate assess-
ment of the financial distress risk. These methods are based on financial indicators
computed and compared to a benchmark in order to allocate the analyzed firm to
one of two groups: sound firms or financially-distressed firms. Since distress risk in
traditional accounting models is measured by a dichotomous variable which clas-
sifies a company as healthy or financially distressed with respect to a specified
cutoff, this class of models is also known as binary or dichotomous models.
Financial data included in the accounting-based models measure profitability,
liquidity, and solvency ratios. Accounting information is observable, although the
preparation of annual reports produces a delay in the availability of accounting
information due to the fact that reports are not released until the following year. The
relative simplicity and availability of financial information have made these tech-
niques for decades the most popular analytical tool of financial distress assessment
in empirical research.
Bankruptcy prediction models include market variables and accounting vari-
ables while other models include only accounting variables. Beaver et al. (2005)
give three reasons why market-based variables are valuable in predicting
bankruptcy:
(a) Market prices reflect a rich and comprehensive mix of information based on the
financial statements of the firm.
(b) Market-based variables can be measured with “a finer partition of time” (Bea-
ver et al. 2005, p. 110). Financial statements are available at best on a quarterly
basis (for most firms only on a yearly basis), market-based variables are
available on a day-to-day basis.
(c) Market-based variables can provide direct measures of volatility (e.g. standard
deviation of earnings per share).
For the above reasons, they assume that models with market variables have
better predictive power in forecasting bankruptcy than models with only accounting
variables.
Agarwal and Taffler (2006) compare market-based and accounting based bank-
ruptcy prediction models by analyzing all listed UK non-finance firms during the
period 1985–2001. They mention two advantages of accounting-based models:
(a) Bankruptcy is not a sudden event but the result of several years of adverse
performance. This is captured by the financial statements of the firm.
(b) The loans which firms have taken out are generally based on accounting
numbers and this information is reflected in the financial statements of the
firms.
One of the main reasons why accounting-based models are popular among
practitioners is that the necessary data for the market-based models is not always
available.
On the other hand, Agarwal and Taffler (2006) argue that accounting based
models casts doubt on their validity because:
– Accounting information contains data on past performance and therefore is not
useful for predicting;
– “Conservatism and historical cost accounting mean that the true asset values
may be very different from the recorded book values” (Agarwal and Taffler
2006, p. 2);
– The accounting numbers are subject to manipulation by management;
Hillegeist et al. (2004) and McKee (2003) argue that since financial statements
are prepared on a going-concern basis, they are not suitable to predict bankruptcy.
Despite extensive criticism on the accounting-based models, the results of the
study of Agarwal and Taffler (2006) showed that the accounting-based approach of
References 27
Altman produces significant economic benefit over the market-based approach of

Hillegeist et al. (2004) and Bharath and Shumway (2004).
The accuracy rate of the model of Altman (1968) was 79% and for Hillegeist
et al. (2004) and Bharath and Shumway (2004) 68% and 73% respectively. These
results suggest the use of accounting-based models for predicting bankruptcy. In the
next chapter we provide an empirical analysis of a Logit Regression applied to
Italian manufacturing companies in the period 2007–2015.
References
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Altman, E. I. (1984). The success of business failure prediction models: An international survey.
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Altman, E. I. (1993). Corporate financial distress and bankruptcy: A complete guide to predicting
and avoiding distress and profiting from bankruptcy. New York: Wiley & Sons.
Altman, E. I. (2005). An emerging market credit scoring system for corporate bonds. Emerging
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Altman, E. I., Haldeman, R. G., & Narayanan, P. (1977). Zeta analysis. Journal of Banking and
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system. New York: Salomon Brothers Inc.
Altman, E. I., Danovi, R., & Fallini, A. (2013). Z-score models’ application to Italian companies
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71–111.
Beaver, W. H., McNichols, M. F., & Rhie, J. (2005). Have financial statements become less
informative? Evidence from the ability of financial ratios to predict bankruptcy. Review of
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Bharath, S. T., & Shumway, T. (2004). Forecasting default with the KMV-Merton model. AFA
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Coats, P. K., & Fant, L. F. (1993). Recognizing financial distress patterns using a neural network
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Accounting Research, 10, 167–179.
Edmister, R. (1972). An empirical test of financial ratio analysis for small business failure
prediction. Journal of Financial and Quantitative Analysis, 7, 1477–1493.
Eftekhar, B., Mohammad, K., Ardebili, H. E., Ghodsi, M., & Ketabchi, E. (2005). Comparison of
artificial neural network and logistic regression models for prediction of mortality in head
trauma based on initial clinical data. BMC Medical Informatics and Decision Making, 5, 1–8.
Etheridge, H. L., & Sriram, R. S. (1997). A comparison of the relative costs of financial distress
models: Artificial neural networks, logit and multivariate discriminant analysis. Intelligent
Systems in Accounting, Finance and Management, 6, 235–248.
Grice, J. S., & Dugan, M. T. (2003). Re-estimations of the Zmijewski and Ohlson bankruptcy
prediction models. Advances in Accounting, 20, 77–93.
Hensher, D. A., Jones, S., & Greene, W. H. (2007). An error component logit analysis of corporate
bankruptcy and insolvency risk in Australia. Abacus, 43, 241–264.
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using recent evidence. Akron Business and Economic Review, 19, 52–63.
Keasey, K., & Watson, R. (1991). Financial distress prediction models: A review of their
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Chapter 4
Data Analysis and Empirical Results
In this chapter, we provide a model of bankruptcy prediction setting a logistic

regression. We first apply the original and the revised Altman’s models and we find
they are not significant in the case of Italian manufacturing companies. For this
reason, we propose a new model by re-estimating all the parameters of previous
models. This enables us to estimate the probability of bankruptcy with the best
accuracy.
4.1 Sampling
The initial sample is composed of a total of 10,085 Public Limited Companies

(Italian Societ
a per Azioni) divided into two groups.
Group 1 consists of a paired sample of manufacturing Public Limited Companies
(S.p.A.) chosen on a stratified random basis. The bankrupted distressed group of
companies (Group 2) are manufacturing Public Limited Companies (S.p.A.) that
filed a bankruptcy petition under the period 2007–2015 (see Table 4.1).
The selected firms are stratified by sub-industries (all of them come from
Manufacturing macro-industry) and size, with the asset size of 62,493,000 € on
average for Active companies and 7,215,000 € on average for Failed companies in
2015. Remembering that the two sample groups are not completely homogeneous
(due to industry and size differences), we attempt to make a careful selection of
non-bankrupted (non-distressed) firms in order to avoid differences among firms.
Descriptive statistics regarding financial data of Active companies (Group 1) are
following reported (€/000) (Table 4.2).
On the other hand, we also elaborate the statistics of financial data for Failed
companies (Group 2) (€/000) (Table 4.3).
Moreover, the collected data were gathered from the same years as those
compiled for the bankrupt firms.

DOI 10.1007/978-3-319-67355-4_4
30 4 Data Analysis and Empirical Results
Table 4.1 Sample Companies # %

Group 1 (Active) 9302 92.24
Group 2 (Failed in 2007–2015) 783 7.76
Total 10,085 100
For the initial sample test, the data are derived from financial statements dated
two annual reporting periods prior to bankruptcy. Our data are gathered from the
AIDA dataset (Italian Database of Companies), which is the Italian provider of the
Bureau Van Dijk European Database; it is the most complete and reliable source of
financial information with respect to Italian companies. The AIDA database con-
tains detailed information with up to 10 years of history of approximately 1,170,000
Italian listed and non-listed companies.
4.2 Variables Description
Regarding all the firms selected (Active and Failed), financial data on balance sheet
and income statement were collected in order to compute the variables. The vari-
ables are classified into five standard ratio categories (Altman 1968):
– Liquidity
Liquidity describes the degree to which an asset or security can be quickly
bought or sold in the market without affecting the price of the asset. Accounting
liquidity measures the ease with which an individual or company can meet their
financial obligations with the liquid assets available to them.
We use the index Working Capital/Total Assets, where Working Capital
Ratio represents current assets minus current liabilities. Current assets are liquid
cash, and assets convertible to cash within one year. It includes stocks, cash, and
cash equivalents available with the company, marketable securities, accounts
receivables, inventories, and prepaid expenses. Current liabilities include
accounts payable, notes payable, current maturities of deposits taken, and
accrued liabilities.
– Profitability
Profitability is simply the capacity to make a profit, and a profit is what is left
over from income earned after you have deducted all costs and expenses related
to earning the income.
Profitability ratios are a class of financial metrics that are used to assess a
business’s ability to generate earnings compared to its expenses and other
relevant costs incurred during a specific period of time.
We use the index Retained Earnings/Total Assets.
4.2 Variables Description
Table 4.2 Descriptive statistics Group 1

Average values 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Total sales 45,232 47,879 49,294 40,726 46,403 51,107 50,061 49,371 50,277 51,764
Operating profit 1998 2224 1583 861 1489 1366 1030 1221 1558 1860
Net profit 1079 1175 566 168 856 476 84 360 1383 1193
Current assets 28,431 30,300 30,983 29,512 31,442 33,020 32,895 34,155 34,467 34,232
Current debts 22,638 24,931 25,276 23,417 25,292 27,066 27,524 28,089 28,050 28,457
Total assets 46,844 50,105 53,783 52,498 55,204 57,258 57,689 58,741 60,078 62,493
Total debts 27,570 30,316 32,031 30,408 32,423 34,062 34,055 34,534 34,449 35,434
Equity 15,532 16,142 17,981 18,239 18,947 19,260 19,727 20,298 21,725 23,236
31
32
Table 4.3 Descriptive statistics Group 2

Average values 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Total sales 17,843 18,558 18,713 14,229 14,474 15,103 12,696 10,502 9851 2166
Operating profit 90 147 1325 1639 1646 2152 3286 2855 3706 1184
Net profit 686 958 2314 2427 2254 3176 4583 4144 5784 1526
Current assets 13,439 14,181 14,166 12,129 12,059 11,610 9762 8731 7575 2692
Current debts 12,978 13,703 15,050 13,948 14,151 15,652 15,673 15,235 15,432 10,358
Total assets 21,394 21,952 24,053 22,364 22,780 21,853 19,315 17,181 14,053 7215
Total debts 16,151 16,936 18,672 18,070 18,831 19,672 19,798 18,992 19,342 14,025
Equity 3729 3582 3764 2531 1972 146 2587 4022 7921 7776
4 Data Analysis and Empirical Results
4.3 The Application of Altman’s Model 33
– Operating Efficiency
Operational efficiency is a market condition that exists when participants can
execute transactions and receive services at a price that equates fairly to the
actual costs required to provide them.
We use Operating Profit/Total Assets.
– Leverage
Companies rely on a mixture of owners’ equity and debt to finance their
operations. A leverage ratio is any one of several financial measurements that
look at how much capital comes in the form of debt (loans), or assesses the
ability of a company to meet financial obligations.
Our ratio is measured as Total Financial Debts/Total Equity.
– Competition/Asset Turnover
Asset turnover ratio is the ratio of the value of a company’s sales or revenues
generated relative to the value of its assets. The Asset Turnover ratio can often
be used as an indicator of the efficiency with which a company is deploying its
assets in generating revenue.
Our ratio is proxied by Total Sales Revenue/Total Assets.
The above variables are selected on the basis of their popularity in the literature
and their potential relevancy to the study. The contribution of the entire profile is
evaluated and, since the process is essentially iterative, there is no claim regarding
the optimality of the resulting discriminant function.
In the following tables we report the descriptive statistics for both groups of
Italian manufacturing companies regarding the five variables analyzed (Tables 4.4
and 4.5).
In order to arrive at a final profile of variables, the following procedures are used:
1. Observation of the statistical significance of various alternative functions includ-
ing the determination of the relative contributions of each independent variable.
2. Evaluation of intercorrelations among the relevant variables.
3. Observation of the predictive accuracy of the various profiles.
4. Judgment of the analyst
4.3 The Application of Altman’s Model
At first, we decide to apply the two versions of Altman’s model: the original one
dated 1968 and the revised one originally formulated in 1993. The goal in this
section is to assess the power prediction of the two models thus see whether they
can be applied to our sample of Italian manufacturing companies.
We started to apply the Original Z-Score to our sample of Failed and Active
companies. This is what emerged from the results (Table 4.6):
We started to apply the Original Z-Score to our sample of Failed and Active
companies. This is what emerged from the results (Table 4.7):
The original Altman’s model (1968) was found to be 41.89% accurate in
predicting bankruptcy 2 years before bankruptcy of our sample. However, the
Table 4.4 Average values (2006–2015) of Indicators (Group 1—Active companies)

Group 1 Obs Mean Min Max Dev st
Working capital/total assets 9302 0.169 20.097 0.996 0.471
Retained earnings/total assets 9302 0.015 0.852 4.419 0.082
Operating profit/total assets 9302 0.038 3.279 0.825 0.078
Total debts/total equity 9302 3.800 511.049 4532.336 69.265
Sales revenues/total assets 9302 0.983 0.000 30.847 0.580
Table 4.5 Average values (2006–2015) of Indicators (Group 2—Failed companies)

Group 2 Obs Mean Min Max Dev st
Working capital/total assets 783 1.036 505.717 0.906 18.524
Retained earnings/total assets 783 0.115 12.565 25.483 1.098
Operating profit/total assets 783 0.087 6.786 6.086 0.385
Total debts/total equity 783 4.979 286.674 897.054 50.542
Sales revenues/total assets 783 0.758 0.000 8.549 0.545
Table 4.6 Original and revised Altman’s models

Original Altman’s model Revised Altman’s model
Coefficient Ratio Coefficient Ratio
1.2 Working capital/total 0.717 Working capital/total assets
assets
1.4 Retained earnings/ 0.847 Retained earnings/total
total assets assets
3.3 Operating profit 3.107 Operating profit (EBIT)/total
(EBIT)/total assets assets
0.60 MVE/total liabilities 0.420 BVE/total liabilities
0.99 Sales revenues/total 0.998 Sales revenues/total assets
assets
Original ‐ Revised ‐
Z ¼ 1.2X1 + 1.4X2 + 3.3X3 + 0.60X4 + 0.99X5 Z ¼ 0.717X1 + 0.847X2 + 3.107X3 + 0.420X4 + 0.998X5
Table 4.7 Power of predicting in 2-years before bankruptcy of original Altman’s model for Failed
companies
Original Altman’s model (1968) for
Failed companies Obs %
Power of predicting in the 2-years before Companies at risk 328 41.89
bankruptcy Companies in grey area 94 12.01
Companies not at risk 361 46.10
Total 783 100.00
model is not significant at 46.10% level since 361 out of 783 Failed companies have
found to be safe instead of distressed (Type Error II) (Table 4.8).
Considering the Active companies, the original Altman’s model (1968) was found
to be accurate at 22.39% while it is not significant at 36.13% (type Error I). In this
4.3 The Application of Altman’s Model 35
Table 4.8 Power of predicting on average before bankruptcy of original Altman’s model for
Failed companies
Original Altman’s model (1968) for
Power of predicting on average Companies at risk 328 41.89
before bankruptcy Companies in grey area 94 12.01
Total 783 100.00
Table 4.9 Power of predicting in 2-years before bankruptcy of Revised Altman’s model for
Failed companies
Revised Altman’s model (1993) for
Power of predicting in the year Companies at risk 307 39.21
before bankruptcy Companies in grey area 180 22.99
Total 783 100.00
Table 4.10 Power of predicting on average before bankruptcy of Revised Altman’s model for
Failed companies
Revised Altman’s model (1993) for
Active companies Obs %
Power of predicting on average in the Companies at risk 1317 14.16
years 2007–2015 Companies in grey area 5835 62.73
Total 9302 100.00
case, the model has a very low predictive power; in addition, most companies
(47.47%) are considered to be in a condition of uncertainty.
Overall, the original model has a weak ability to predict bankruptcy.
Then we applied the Revised Altman’s model for Failed companies to see what
emerged in our analysis (Table 4.9).
The Revised Altman’s model (1993) was found to be 39.21% accurate in
predicting bankruptcy two years before bankruptcy of our sample. However, the
model is not significant at 37.80% since 296 out of 783 Failed companies were
found to be safe instead of distressed (Type Error II) (Table 4.10).
Considering the Active companies, the revised Altman’s model (1993) was
found to be only 14.16% accurate while it is not significant at 23.11% (Type
Error I). In this case, the model has a lower predictive power than the original
model; in addition, the vast majority of Active companies (62.73%) were consid-
ered in a condition of uncertainty.
Overall, the revised model has a weaker ability to predict bankruptcy than the
original one.
4.4 Logistic Regression
Considering the lower predictive power of both models, we propose a new model of
bankruptcy prediction for Italian manufacturing companies by re-estimating the
parameters of Altman’s.
We elaborate a Logistic Regression in order to assess the probability of
bankruptcy.
4.4.1 Overview
Logistic regression is an approach to prediction, like Ordinary Least Squares (OLS)

regression. However, with logistic regression, the researcher is predicting a dichot-
omous outcome. The main assumptions of OLS lie in the normal distribution of the
error variances (residuals).
On the contrary, they are more likely to follow a logistic distribution. When
using the logistic distribution, we need to make an algebraic conversion to arrive at
our usual linear regression equation (which we have written as Y ¼ B0 + B1X + e).
With logistic regression, there is no standardized solution printed. And to make
things more complicated, the non-standardized solution does not have the same
straightforward interpretation as it does with OLS regression. One other difference
between OLS and logistic regression is that there is no R2 to gauge the variance
accounted for in the overall model (at least not one that has been agreed upon by
statisticians). Instead, a chi-square test is used to indicate how well the logistic
regression model fits the data.
Probability that Y ¼ 1
Because the dependent variable is not a continuous one, the goal of logistic
regression is a bit different, because we are predicting the likelihood that Y is equal
to 1 (rather than 0) given certain values of X. That is, if X and Y have a positive
linear relationship, the probability that a person will have a score of Y ¼ 1 will
increase as values of X increase. So, we are stuck with thinking about predicting
probabilities rather than the scores of dependent variables.
In logistic regression, a complex formula is required to convert back and forth
from the logistic equation to the OLS-type equation. The logistic formulas are
stated in terms of the probability that Y ¼ 1, which is referred to as p^.
The probability that Y is 0 is 1 p^.
4.4 Logistic Regression 37

p^
ln ¼ B 0 þ B1 X
1 p^
The ln symbol refers to a natural logarithm and B0 + B1H is the equation for the
regression line.
P can be computed from the regression equation also. So, if we know the
regression equation, we could calculate the expected probability that Y ¼ 1 for a
given value of X.
expðB0 þ B1 XÞ eB0 þB1 x

p^¼ ¼
1 þ expðB0 þ B1 xÞ 1 þ eB0 þB1 x
Exp is the exponent function, written as e.1 So, the equation on the right is the
same but exp has been replaced with e (that is not the residual).
4.4.2 Interpretation of Coefficients
Because of these complicated algebraic translations, our regression coefficients are

not easy to interpret. Our old maxim that b represents “the change in Y with one unit
change in X” is no longer applicable. Instead we have to translate using the
exponent function. And as it turns out, when we do that we have a type of
coefficient that is quite useful. This coefficient is called the odds ratio.
4.4.3 Logistic Regression Model Fit
When selecting the model for the logistic regression analysis, another important
consideration is the model fit. Adding independent variables to a logistic regression
model will always increase its statistical validity, because it will always explain a
bit more variance of the log odds (typically expressed as R2). However, adding
more and more variables to the model makes it inefficient and over fitting occurs.
For this reason we decided to keep the five variables provided by Altman in its
z-score without adding any further variables.
Nevertheless, many experts want an equivalent way of describing how good a
particular model is, and numerous pseudo-R2 values have been developed.
1
Exp, the exponential function, and ln, the natural logarithm are opposites. The exponential
function involves the constant with the value of 2.7183. When we take exponential function of a
specific number, we take 2.7183 raised to the power of the number. So, exp(3) equals 2.7183
cubed ¼ 20.09. On the other hand, if we take ln(20.09), we get the number of 3.
In this context, pseudo-R2 should be interpreted with extreme caution as they

have many computational issues which cause them to be artificially high or low. A
better approach is to present any of the goodness of fit tests available; “Cox and
Snell” and “Nagelkerke” are commonly used measures of goodness of fit based on
the Chi-square test (which makes sense given that logistic regression is related to
cross tabulation). In our study we use the Nagelkerke test for measuring the
goodness of fit model and it can be thought of as a chi-square value.
4.5 Our Logistic Model for Italian Manufacturing Public

Limited Companies (S.p.A.)
In order to make our original Logit model for Italian manufacturing Public Limited
Companies (S.p.A.), we inserted all the five variables in an excel spreadsheet
coding “1” for Failed companies and “0” for Active companies. Afterwards, we
copied and pasted all the data in an SPSS sheet.
We inserted the values of each variable in the SPSS spreadsheet together with
code “1” for Failed companies and “0” for Active companies.
4.5 Our Logistic Model for Italian Manufacturing Public Limited Companies (S.p.A.) 39
The LOGIT regression results are following exposed:

Recap cases elaborations
N Percentage
Selected cases Included in the analysis 10,085 97.5
Missing cases 259 2.5
Total 10,344 100.0
Not selected cases 0 0.0
Total 10,344 100.0
Model recap
2 LOG likelihood R-squared of Cox and Snell R-squared of Nagelkerke
4619.130 0.084 0.200
Classification table
Predicted
Y_Failed_NoFailed
Observed 0.000 1.000 Correct percentage
Y_Failed_NoFailed 0.000 9231 71 99.2
1.000 695 88 11.2
Global percentage 92.4
Logistic regression—output variables

B E.S. Wald df Sig. Exp(B)
WC/TA 0.268 0.064 17.388 1 0.000 0.765
RE/TA 0.461 0.348 1.758 1 0.185 0.631
OP/TA 10.151 0.629 260.775 1 0.000 0.000
Debts/Equity 0.000 0.000 0.051 1 0.822 1.000
Sales/TA 0.385 0.094 16.789 1 0.000 0.680
Constant 2.117 0.087 588.565 1 0.000 0.120
Inserted variables: WC/TA, RE/TA, OP/TA, Debts/Equity, Sales/TA
As you can see from the Output table, var2 (RE/TA) and var4 (Debts/equity) are
not significant at all (respectively, 0.185 and 0.822). For this reason, we decided to
re-estimate the parameters taking out the above variables to better perform the
model.
The new output is reported as follows:
Model recap
2 LOG Likelihood R-squared of Cox and Snell R-squared of Nagelkerke
4632.764 0.083 0.197
Logistic regression—output variables

B E.S. Wald df Sig. Exp(B)
WC/TA 0.260 0.065 15.875 1 0.000 0.771
OP/TA 10.428 0.508 421.107 1 0.000 0.000
Sales/TA 0.379 0.094 16.376 1 0.000 0.685
Constant 2.112 0.087 589.810 1 0.000 0.121
Omitted variables because not significant: RE/TA and Debts/Equity
Compared to the first logistic regression, the coefficients have changed slightly
so that our model becomes:
Y ð1j0Þ ¼ β0 þ β1 X1 þ . . . þ βn Xn
Working Capital Operating Profit

Y ð1j0Þ ¼ 2:117 0:260 10:428
Total Assets Total Assets
Sales
0:379
Total Assets
expðβ0 þ β1 X1 þ . . . þ βn Xn Þ eβ0 þβ1 X1 þ...þβn Xn

Pi ¼ ¼
1 þ expðβ0 þ β1 X1 þ . . . þ βn Xn Þ 1 þ eβ0 þβ1 X1 þ...þβn Xn
Where P is the probability of bankruptcy for the company i.
4.6 Empirical Results
Table above shows the results of the model of Altman in predicting financial
distress (Original and Revised). The analysis of the results indicates that the two
models are not accurate applied to Italian companies.
The first version of Altman’s model (the original one) was found to be 41.89%
accurate in predicting bankruptcy, however the model is not significant at a level of
46.10% since 361 out of 783 Failed companies are classified as “not at risk” (Type
Error II). With regard to the Active companies, the original Altman’s model (1968)
has a very low predictive power: it is accurate at 22.39% while it is only considered
significant at 36.13% (type Error I).
The second-version of Altman’s model (the revised one) is accurate at 39.21% in
estimating bankruptcy but it is only considered significant at 37.80% since 296 out
of 783 Failed companies are classified as “not at risk” (Type Error II). Regarding
the Active companies, the model is accurate at a mere 14.16% while it is not
significant at 23.11% (Type Error I). Furthermore, a large percentage of Active
companies are included in the grey area (62.73%).
4.6 Empirical Results 41
The second-version model has a lower predictive power than the original model.
Both models have a weak ability to predict bankruptcy.
For this reason, we seek to overcome the above limits of Altman’s models by
providing our own model to predict financial distress and to estimate the probability
of bankruptcy for Italian manufacturing companies.
According to our Logistic regression implemented in the previous paragraph we
come to the new elaboration of Altman model, below reported:
Working Capital Operating Profit
Y ð1j0Þ ¼ 2:117 0:260 10:428
Total Assets Total Assets
Sales
0:379
Total Assets
Where only three variables (WC/TA, OP/TA and Sales/TA) are considered
significant to estimate the probability for bankruptcy.
4.6.1 Example on How to Use Our New Model
Period 2007–2015 WC/TA RE/TA OP/TA DEB/PN Sales/TA

Company xyz S.P.A. 0.5321 0.1210 0.1601 0.5350 0.8430
We consider a random active Italian company (Company xyz S.p.A.) to see how
our model has to be set. In the table above we report the average values
(2007–2015) of the five indicators. Notice that we do not use RE/TA and
DEB/PN since they are not statistically significant.
Y ð1j0Þ ¼ 2:117 0:260 ð0:5321Þ 10:428ð0:1601Þ 0:379ð0:8430Þ
Y ð1j0Þ ¼ 4:2444
expð2:117 0:260 ð0:5321Þ 10:428ð0:1601Þ 0:379ð0:8430ÞÞ

Pi ¼ ¼
1 þ expð2:117 0:260 ð0:5321Þ 10:428ð0:1601Þ 0:379ð0:8430ÞÞ
e2:1170:260 ð0:5321Þ10:428ð0:1601Þ0:379ð0:8430Þ
¼ ¼
1 þ e2:1170:260 ð0:5321Þ10:428ð0:1601Þ0:379ð0:8430Þ
e4:2444
¼ ¼
1 þ e4:2444
0:01434
¼ ¼
1 þ 0:01434
¼ 0:01413 ¼
¼ 1:41%
42
Table 4.11 Correlation matrix

WC_TA RE_TA OP_TA Debts_Equity Sales_TA Y_Failed_NoFailed
WC_TA Pearson’s Correlation 1 0.108** 0.124** 0.000 0.034** 0.062**
Sig. (2-code) 0.000 0.000 0.988 0.001 0.000
N 10,085 10,085 10,085 10,085 10,085 10,085
RE_TA Pearson’s Correlation 0.108** 1 0.397** 0.004 0.035** 0.109**
Sig. (2-code) 0.000 0.000 0.703 0.000 0.000
N 10,085 10,085 10,085 10,085 10,085 10,085
OP_TA Pearson’s Correlation 0.124** 0.397** 1 0.011 0.159** 0.249**
Sig. (2-code) 0.000 0.000 0.272 0.000 0.000
N 10,085 10,085 10,085 10,085 10,085 10,085
Debts_Equity Pearson’s Correlation 0.000 0.004 0.011 1 0.004 0.005
Sig. (2-code) 0.988 0.703 0.272 0.717 0.648
N 10,085 10,085 10,085 10,085 10,085 10,085
Sales_TA Pearson’s Correlation 0.034** 0.035** 0.159** 0.004 1 0.105**
Sig. (2-code) 0.001 0.000 0.000 0.717 0.000
N 10,085 10,085 10,085 10,085 10,085 10,085
Y_Failed_NoFailed Pearson’s Correlation 0.062** 0.109** 0.249** 0.005 0.105** 1
Sig. (2-code) 0.000 0.000 0.000 0.648 0.000
N 10,085 10,085 10,085 10,085 10,085 10,344
**Correlation is significant at 0.01 (2-code)
4 Data Analysis and Empirical Results
Reference 43
In the case of Company xyz S.p.A., we compute a probability of bankruptcy

equal to 1.41% considered to be accurate in predicting bankruptcy. The analyzed
company has a very low probability of bankruptcy thus it is considered safe.
In order to make deeper investigations, it is also possible to compute the
probability for other companies of the same industry in order to make interesting
comparisons and have different benchmarks (Table 4.11).
Reference
Chapter 5
Conclusions and Implications
5.1 Conclusive Remarks
In finance and accounting research, financial distress and bankruptcy prediction

models may be used as risk measures in many different contexts. Where financial
distress and bankruptcy prediction modeling is not the primary focus, it would be
time-consuming, uneconomical, and superfluous to first estimate a failure predic-
tion model (or models) and then study the phenomenon of interest.
This study was inspired by the empirical phenomenon of Italian financially
distressed companies and contributes new insights to this already extended and
complex field of accounting and financial research. We seek to deliver a compre-
hensive theoretical framework of the statistical models of corporate failure. In such
instances, a well-tested general model that works reliably and consistently across
different countries is highly desirable. Based on our empirical tests in this study, our
re-estimated version of Altman’s model containing the five study variables with
coefficients re-estimated using a large dataset of Italian manufacturing firms works
consistently and is easy to implement and interpret. Therefore, this kind of
accounting-based model can be used by all interested parties, especially interna-
tionally active banks, financial institutions, practitioners, and researchers, not only
for failure or distress prediction but also for other managerial purposes such as
provisioning and economic capital calculation.
5.2 Implications for Scholars and Practitioners
Our research takes the scientific community a bit forward in the understanding of
what the meaning of corporate financial distress process is, what the determinants
of financial distress are according to the previous literature, whether Altman’s

DOI 10.1007/978-3-319-67355-4_5
46 5 Conclusions and Implications
model can be applied to an Italian context and what a new model for Italian Public
Limited Companies (Societa Per Azioni) could be.
The whole academic discussion was triggered by practitioners whom can par-
ticularly benefit in the following ways:
– By learning what happens with the value of the company in financial distress and
how risk affects the deteriorating performance of the bankruptcy candidate.
– By learning which strategic and operational factors signal aggravation of a
financial situation within Italian Public Limited Companies (S.p.A.) so as to
detect an early warning system to avoid the worsening of financial distress and
bankruptcy.
As any other empirical study, our work is not entirely free of limitations; this can
be regarded as a starting point for future research. We did not combine different
types of variables (accounting ratios, market variables, and macroeconomic indi-
cators) for financial distress/prediction models since we only focus on financial
indicators gathered from income statements and balance sheets. In particular,
macro-economic factors such as inflation and economic growth may overcome
this limit and provide a better representation of our model. Therefore, further
research should investigate the aforementioned factors using macro-economic
variables.
Another fruitful area is the linkage between financial distress and corporate
governance, which might receive growing attention in the future. The crucial
issue is whether it is mainly the performance and decision making of top manage-
ment that is responsible for the onset of financial distress, or if it is mainly due to
systematic economic or industry factors. If it is managerial incompetence that
causes financial distress, then replacing the managers is important for a successful
reorganization. If it is poorly designed managerial incentives, then managerial
turnover alone is unlikely to resolve the firm’s problem. Overall, a great deal of
literature suggests that no matter what causes a firm’s financial distress and,
eventually, bankruptcy, significant changes in the firm’s management, incentive
mechanisms, governance and control structure are all a crucial part of the financial
distress resolution.
Although many studies have been published on the matter, we strongly believe
that corporate financial distress is still a very young field of theoretical and
empirical research therefore we invite theoreticians and practitioners to find
whether determinants/variables of previous models are still significant in different
contexts (in this work we focus on Italy) and what other indicators affecting the
probability of bankruptcy in a specific context could be. We address other
researchers in order to continue the examination of this challenging and promising
area of modern accounting and finance.
Further research should focus on other modifications and/or extensions of those
presented in our paper, such as using alternative modeling techniques (e.g., panel
data analysis), introducing new variables (e.g., macroeconomic data), and testing its
usefulness with data from other countries (e.g., emerging markets).

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SPRINGER BRIEFS IN FINANCE

Corporate Financial Distress

ISSN 2193-1720 ISSN 2193-1739 (electronic)

Library of Congress Control Number: 2017951120

© The Author(s) 2017

Printed on acid-free paper

This Springer imprint is published by Springer Nature

Companies have experienced bankruptcy throughout history. Bankruptcy results in

Naples, Italy Matteo Pozzoli

4.5 Our Logistic Model for Italian Manufacturing Public Limited

Matteo Pozzoli, Ph.D., is Associate Professor of Business Administration at the

Francesco Paolone holds a degree in Business Administration and Management at

© The Author(s) 2017 1

2.2 From Decline to Crisis

© The Author(s) 2017 3

Table 2.1 Factors that can represent causes of a decline

2.3 From Crisis to Financial Distress

2.4 From Financial Distress to Bankruptcy

Bankruptcy is sometimes perceived as a natural or most likely outcome of a

3.1 Models of Corporate Financial Distress Risk

© The Author(s) 2017 11

3.2 Beaver’s Univariate Analysis (1966)

Table 3.1 The ratios of Beaver (1966)

Table 3.2 Misclassified test Fraction misclassified using dichotomous test

3.3 Altman’s Multivariate Analysis (1968)

Following the model of Beaver, many researchers investigated multivariate tech-

He developed a statistical method called multiple discriminant analysis (MDA)

X1, X2, . . ., Xn are the set of predictor variables (ratios).

Z-Score ¼ 0:012X1 þ 0:014X2 þ 0:033X3 þ 0:006X4 þ 0:999X5

Table 3.4 Significant test of Altman (1968, p. 596)

Table 3.5 Accuracy prediction of Altman (1968, p. 604)

3.4 The Model of Ohlson (1980)

Ohlson (1980) criticizes the restrictive assumptions of multiple discriminant anal-

introduces an alternative econometric technique based on the logistic transforma-

Failing: is 0 for failed firm-years and 1 for other firm-years.

ðzÞ ¼ 11 þ eðzÞ ¼ 11 þ eðw0 þw1 x1 þþwn xn Þ

Ohlson chooses his default predictors based on the frequency of appearance in

The higher the O-Score, the higher the risk of default.

3.5 The Model of Zmijewski (1984)

The Zmijewski Score is a bankruptcy model used to predict a firm’s bankruptcy in

3.6 The Neural Networks of Etheridge and Sriram (1997)

Table 3.6 Resume of the main models of Bankruptcy prediction

Table 3.7 Statistical techniques in corporate financial distress studies

3.7 Other Models of Financial Distress

– Debt service (which is measured by taking the log 10 of familiar interest

3.8 Accounting-Based or Market-Based Models?

The Accounting-based models investigate the importance of the use of information

Altman produces significant economic benefit over the market-based approach of

In this chapter, we provide a model of bankruptcy prediction setting a logistic

The initial sample is composed of a total of 10,085 Public Limited Companies

© The Author(s) 2017 29

Table 4.1 Sample Companies # %

4.2 Variables Description

Table 4.2 Descriptive statistics Group 1

Table 4.3 Descriptive statistics Group 2

4.3 The Application of Altman’s Model

Table 4.4 Average values (2006–2015) of Indicators (Group 1—Active companies)

Table 4.5 Average values (2006–2015) of Indicators (Group 2—Failed companies)

Table 4.6 Original and revised Altman’s models

4.4 Logistic Regression

Logistic regression is an approach to prediction, like Ordinary Least Squares (OLS)

expðB0 þ B1 XÞ eB0 þB1 x

4.4.2 Interpretation of Coefficients