Ratio Stability and Corporate Failure

THIS STUDY PRESENTS ANOTHER model on corporate failure that uses financial ratios and discriminant analysis as its core. We believe the final word on this methodology has not yet been said. The essential attribute of our model is its use of the stability of all financial ratios over time, as well as the level of these ratios, as explanatory variables in the derivation of a discriminant function. Our research indicated a substantial degree of instability, measured by (1) the standard deviation of the financial ratios over the past few years, (2) their standard error of estimate, and (3) their coeffilcient of variation, in the ratios of firms that went bankrupt when compared with those that did not. This instability showed a significant increase over time as the corporation approached failure (Figure 1). The inclusion of the stability of ratios in the analysis improved considerably the ability of the discriminant function to predict failure. Our model classified firms into failed and non-failed groups with 78 percent accuracy five years prior to failure. This represents a marked improvement over previously reported results. The next section outlines the milestones of recent corporate failure research. Then the characteristics of our data set are described. Following that we describe our methodology and present our results. Finally, a summary is made of our main conclusions.