Taking the Twists into Account: Predicting Firm Bankruptcy Risk with Splines of Financial Ratios

Riksbank Research Paper Series No. 87

Sveriges Riksbank Working Paper Series, No. 256

47 Pages Posted: 23 Feb 2012

See all articles by Paolo Giordani

Paolo Giordani

Sveriges Riksbank - Research Division

Tor Jacobson

Sveriges Riksbank - Research Division

Erik L. von Schedvin

Sveriges Riksbank

Mattias Villani

Linkoping University

Date Written: November 2011

Abstract

We demonstrate improvements in predictive power when introducing spline functions to take account of highly non-linear relationships between firm failure and earnings, leverage, and liquidity in a logistic bankruptcy model. Our results show that modeling excessive non-linearities yields substantially improved bankruptcy predictions, on the order of 70 to 90 percent, compared with a standard logistic model. The spline model provides several important and surprising insights into non-monotonic bankruptcy relationships. We find that low-leveraged and highly profitable firms are riskier than given by a standard model. These features are remarkably stable over time, suggesting that they are of a structural nature.

Keywords: bankruptcy risk model, micro-data, logistic spline regression, financial ratios

JEL Classification: C41, G21, G33, G38

Suggested Citation

Giordani, Paolo and Jacobson, Tor and von Schedvin, Erik L. and Villani, Mattias, Taking the Twists into Account: Predicting Firm Bankruptcy Risk with Splines of Financial Ratios (November 2011). Riksbank Research Paper Series No. 87. Available at SSRN: https://ssrn.com/abstract=1972884 or http://dx.doi.org/10.2139/ssrn.1972884

Paolo Giordani (Contact Author)

Sveriges Riksbank - Research Division ( email )

S-103 37 Stockholm
Sweden

HOME PAGE: http://www.riksbank.com/templates/Page.aspx?id=22013

Tor Jacobson

Sveriges Riksbank - Research Division ( email )

S-103 37 Stockholm
Sweden
+46 8 787 0000 (Phone)

HOME PAGE: www.riksbank.com

Erik L. Von Schedvin

Sveriges Riksbank ( email )

Brunkebergstorg 11
SE-103 37 Stockholm
Sweden

Mattias Villani

Linkoping University ( email )

Ă–verstegatan 30
Linkoping, 581 83
Sweden

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