Predicting Corporate Bankruptcy

11 Pages Posted: 23 Jun 2009

See all articles by Mark E. Haskins

Mark E. Haskins

University of Virginia - Darden School of Business

Phillip E. Pfeifer

University of Virginia - Darden School of Business

Abstract

This note describes a study of the important predictors of corporate bankruptcy. Twenty-four financial ratios for a paired sample of fifty healthy and bankrupt firms are provided. Students are asked to develop a predictive model of corporate bankruptcy using these data. A hold-out sample is used to test their predictions.

Excerpt

UVA-QA-0371

PREDICTING CORPORATE BANKRUPTCY

Just as doctors check blood pressure and pulse rate as vital indicators of the health of a patient, so 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 non‑cash 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 gain 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?

. . .

Keywords: bankruptcy, financial ratios, financial-sstatement analysis, regression analysis, statistics

Suggested Citation

Haskins, Mark E. and Pfeifer, Phillip E., Predicting Corporate Bankruptcy. Darden Case No. UVA-QA-0371. Available at SSRN: https://ssrn.com/abstract=1422923

Mark E. Haskins (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924 -4826 (Phone)

HOME PAGE: http://www.darden.virginia.edu/faculty/haskins.htm

Phillip E. Pfeifer

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4803 (Phone)

HOME PAGE: http://www.darden.virginia.edu/faculty/Pfeifer.htm

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