Predicting Corporate Bankruptcy
Just as doctors check blood pressure and pulse rate as vital indicators of the health of a patient,
business analysts scour the financial statements of a corporation to monitor its financial health.
Whereas blood pressure, pulse rate, and most medical vital signs, however, are measured through
precisely defined procedures, financial variables are recorded under much less specific general
principles of accounting. A primary issue in financial analysis, then, is how predictable is the
health of a company?
One difficulty in analyzing financial report information is the lack of disclosure of actual cash
receipts and disbursements. Users of financial statements have had to rely on proxies for cash
flow, perhaps the simplest of which is income (INC) or earnings per share. Attempts to improve
INC as a proxy for cash flow include using income plus depreciation (INCDEP), working capital
from operations (WCFO), and cash flow from operations (CFFO). CFFO is obtained by
adjusting income from operations for all noncash expenditures and revenues and for changes in
the current asset and current liabilities accounts.
A further difficulty in interpreting historical financial disclosure information is caused whenever
major changes are made in accounting standards. For example, the Financial Accounting
Standards Board issued several promulgations in the middle 1970s that changed the requirements
for reporting accruals pertaining to such things as equity earnings, foreign currency gains and
losses, and deferred taxes. One effect of changes of this sort was that earnings figures became
less reliable indicators of cash flow.
In the light of these difficulties in interpreting accounting information, just what are the
important vital signs of corporate health? Is cash flow an important signal? If not, what is? If so,
what is the best way to approximate cash flow? How can we predict the impending demise of a
company? To begin to answer some of these important questions, we conducted a study of the
financial vital signs of bankrupt and healthy companies. We first identified 66 failed firms from a
list provided by Dun and Bradstreet. These firms were in manufacturing or retailing and had
financial data available on the Compustat Research tape. Bankruptcy occurred somewhere
between 1970 and 1982.
For each of these 66 failed firms, we selected a healthy firm of approximately the same size (as
measured by the book value of the firm’s assets) from the same industry (3 digit SIC code) as a
basis of comparison. This matched sample technique was used to minimize the impact of any
extraneous factors (such as industry) on the conclusions of the study.
The study was designed to see how well bankruptcy can be predicted 2 years in advance. A total
of 24 financial ratios were computed for each of the 132 firms using data from the Compustat
tapes and from Moody’s Industrial Manual for the year that was 2 years prior to the year of
bankruptcy. Table 1 lists the 24 ratios together with an explanation of the abbreviations used for
the fundamental financial variables. All these variables are contained in a firm’s annual report
with the exception of CFFO. Ratios were used to facilitate comparisons across firms of various
sizes.
The first four ratios using CASH in the numerator might be thought of as measures of a firm’s
cash reservoir with which to pay debts. The three ratios with CURASS in the numerator capture
the firm’s generation of current assets with which to pay debts. Two ratios, CURDEBT/DEBT
and ASSETS/DEBTS, measure the firm’s debt structure. Inventory and receivables turnover are
measured by COGS/INV and SALES/REC, and SALES/ASSETS measures the firm’s ability to
generate sales. The final 12 ratios are asset flow measures.
Table 1: Financial Variables and Ratios
Abbreviation Financial Variable Ratio Definition
ASSETS Total assets R1 CASH/CURDEBT
CASH Cash R2 CASH/SALES
CFFO Cash flow from R3 CASH/ASSETS
operations
COGS Cost of goods sold R4 CASH/DEBTS
CURASS Current assets R5 CFFO/SALES
CURDEBT Current debt R6 CFFO/ASSETS
DEBTS Total debt R7 CFFO/DEBTS
INC Income R8 COGS/INV
INCDEP Income plus R9 CURASS/CURDEB
depreciation T
INV Inventory R10 CURASS/SALES
REC Receivables R11 CURASS/ASSETS
SALES Sales R12 CURDEBT/DEBTS
WCFO Working capital from R13 INC/SALES
operations
R14 INC/ASSETS
R15 INC/DEBTS
R16 INCDEP/SALES
R17 INCDEP/ASSETS
R18 INCDEP/DEBTS
R19 SALES/REC
R20 SALES/ASSETS
R21 ASSETS/DEBTS
R22 WCFO/SALES
R23 WCFO/ASSETS
R24 WCFO/DEBTS
Assignment
1. What data mining technique(s) would be appropriate in assessing whether there are
groups of variables that convey the same information and how important that information
is? Conduct such an analysis.
2. Explore the data to gain a preliminary understanding of which variables might be
important in distinguishing bankrupt from non-bankrupt firms.
