Are Industry-Relative Financial Ratios More Stable? The Case of Bankruptcy Prediction

Abstract

Previous research claims that industry-relative financial ratios are more stable than unadjusted ratios. Yet, most bankruptcy studies continue to use unadjusted financial ratios to develop bankruptcy-prediction models. In re-examining whether industry-relative ratios are actually more stable, we find a significant disparity between ex-post and ex-ante classification results both with industry-relative and unadjusted ratios. However, the disparity for industry-relative ratios is significantly smaller. We subsequently develop an industry-relative bankruptcy model based on Altman’s Z-score model that possesses a high classification accuracy one year before bankruptcy. Our results suggest that industry-relative analysis does not necessarily have a higher predictive power; however, it possesses better stability.

Keywords: Bankruptcy prediction; Financial failure; Industry-relative ratio; Logit models

JEL Classification: G01, G32, G33