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JournalofAccountingResearch
Vol. 18 No. 1 Spring1980
Printed in U.S.A.
A. OHLSON*
1. Introduction
This paper presentssome empiricalresultsof a studypredicting
Therehave
corporatefailureas evidencedby the eventofbankruptcy.
of
in
this
field
of
a
number
studies
fair
been
research;themore
previous
contributions
are
Beaver
1968a;
1968b],Altman
[1966;
notablepublished
[1968; 1973],Altmanand Lorris[1976],Altmanand McGough[1974],
Altman,Haldeman,and Narayanan[1977],Deakin[1972],Libby[1975],
Blum [1974],Edmister[1972],Wilcox[1973],Moyer[1977],and Lev
papersby Whiteand Turnbull[1975a; 1975b]
[1971].Two unpublished
as
and a paperby Santomeroand Vinso[1977]are ofparticular
interest
be
the
first
studies
which
and
to
systematically
logically
theyappear
estimatesoffailure.The presentstudyis similarto
developprobabilistic
is one ofmaximum
likelihood
thelatterstudies,in thatthemethodology
ofthesocalledconditional
estimation
logitmodel.
The data setusedin thisstudyis fromtheseventies(197076).I know
of onlythreecorporatefailureresearchstudieswhichhave examined
data fromthisperiod.One is a limitedstudyby Altmanand McGough
[1974]in whichonlyfailedfirmsweredrawnfromthe period197073
error(misclassification
offailedfirms)
and onlyone typeofclassification
was analyzed.Moyer [1977] consideredthe period 196575,but the
firms
The
was unusuallysmall(twentyseven
firms).
sampleofbankrupt
* Associate Professor,Universityof California,Berkeley. I gratefullyacknowledgethe
financialsupportfromthe Wells Fargo Bank. My thanksare also due to R. Wagnerand R.
Benin, who providedable and valuable assistance in the course of the project.G. Feltham,
R. Hamilton, V. Anderson,W. Beaver, and R. Holland supplied valuable commentson
earlierversionsof this paper. [Accepted forpublicationMarch 1979.]
109
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110
JOURNAL
OF
ACCOUNTING
RESEARCH,
SPRING
1980
third study,by Altman, Haldeman, and Narayanan [1977], which "updates" the originalAltman [1968] study,basically considers data from
failed
the period 1969 to 1975. Their sample was based on fiftythree
firmsand about the same number of nonfailedfirms.In contrast,my
studyrelies on observationsfrom105 bankruptfirmsand 2,058nonbankrupt firms.Althoughthe otherthree studies differfromthe presentone
so far as methodologyand objectives are concerned,it is, nevertheless,
interestingand useful to compare theirresultswith those presentedin
this paper.
Another distinguishingfeature of the present study which I should
stress is that, contraryto almost all previousstudies,the data forfailed
firmswere not derivedfromMoody's Manual.' The data were obtained
instead from 10K financial statementsas reported at the time. This
procedure has one importantadvantage: the reports indicate at what
point in time they were released to the public, and one can therefore
check whetherthe companyenteredbankruptcypriorto or afterthe date
of release. Previous studies have not explicitlyconsidered this timing
issue. Some studies,but by no means all, seem implicitlyto presumethat
a reportis available at the fiscalyearenddate. The lattermay or may
not be appropriate,dependingon the purpose of the study.However,if
the purpose is one of investigatingpure forecastingrelationships,as is
the case in this study, then the latter procedure is inadequate. This
followsbecause it is possible that a companyfilesforbankruptcyat some
point in time afterthe fiscalyear date, but priorto releasingthe financial
statements.This is not a trivialproblem and neglectingthis possibility
may lead to "backcasting"formany of the failedfirms.
The major findingsof the study can be summarizedbriefly.First, it
was possible to identifyfourbasic factorsas beingstatisticallysignificant
in affectingthe probabilityoffailure(withinone year). These are: (i) the
size of the company; (ii) a measure(s) of the financialstructure;(iii) a
measure(s) of performance;(iv) a measure(s) of currentliquidity (the
evidence regardingthis factoris not as clear as compared to cases (i)(iii)). Second, previous studies appear to have overstatedthe predictive
(in the sense of forecasting)power of models developed and tested. The
point of concern is the one alluded to above, that is, if one employs
predictorsderivedfromstatementswhichwere released afterthe date of
bankruptcy,thenthe evidence indicatesthat it will be easier to "predict"
bankruptcy.However,even ifone allows forthisfactor,forthe sample of
firmsused in this study,the predictionerrorrateis largerin comparison
to the rate reportedin the originalAltman [1968] study as well as most
other studies using data drawn fromperiods priorto 1970. More important, the prediction errorrateis also larger than the one reported in
Altmanet al. [1977]. On the otherhand,the Altmanand McGough [1974]
' The onlyexceptionappears to be the Altmanand McGough [1974] study.Altmanet al.
[1977] do not describe how theyderivedtheirdata.
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FINANCIAL
RATIOS
AND
BANKRUPTCY
iII
whichare
largererrorrates,
and Moyer [1977] studiesreportsignificantly
comparable to those foundin this study.I have not been able completely
to account forthis most significantdifferencein the errorratesreported
here,in Altman and McGough [1974], and in Moyer [1977], as compared
to Altman et al. [1977]. (Any period dependence should after all be
relativelyminor.)
The model(s) are relativelysimple to apply and may be of use in
practical applications. The data requirementsare such that all of the
predictors are easily retrieved from the Compustat file. A potential
disadvantage is that the model does not utilize any markettransactions
(price) data of the firms.One may, of course, expect that the predictive
power of the model could be enhanced by incorporatingsuch data.'
However, one mightask a basic and possibly embarrassingquestion:
why forecastbankruptcy?This is a difficultquestion,and no answer or
justificationis givenhere.It could,perhaps,be arguedthat we are dealing
with a problemof "obvious" practicalinterest.This is questionable since
realworldproblemsconcernthemselveswithchoices whichhave a richer
set of possible outcomes.No decision problemI can thinkofhas a payoff
space which is partitionednaturallyinto the binarystatus bankruptcy
versus nonbankruptcy.(Even in the case of a "simple" loan decision,the
payoffconfigurationis much more complex.) Existingempiricalstudies
reflectthis problem in that there is no consensus on what constitutes
"failure," with definitionsvarying significantlyand arbitrarilyacross
studies. In otherwords,the dichotomybankruptcyversusno bankruptcy
is, at the most, a very crude approximationof the payoffspace of some
hypotheticaldecision problem. It follows that it is essentially a futile
exerciseto tryto establish the relativedecision usefulnessof alternative
predictivesystems.Accordingly,I have not concernedmyselfwith how
bankruptcy(and/or failure)"ought" to be defined;I also have refrained
frommaking inferencesregardingthe relative usefulnessof alternative
models, ratios, and predictivesystems (e.g., univariateversus multivariate). Most of the analysis should simplybe viewed as descriptivestatisticswhich may, to some extent, include estimated predictionerrorratesand no "theories" of bankruptcyor usefulnessof financialratios
are tested. Even so, there are a large numberof difficultstatisticaland
methodologicalproblems which need to be discussed. Many important
problemspertainingto the developmentof data forbankruptfirmshave
gone mostlyunnoticedin the literature.
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112
JAMES
A. OHLSON
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FINANCIAL
RATIOS
AND
BANKRUPTCY
113
it is beyondthe confines
thoughit is possible to test formisspecification,
of this paper to discuss and reporton the resultsof such tests.)
Regardless of the virtuesof probabilisticpredictionover MDA, there
are importantproblemswithrespectto data collectionofbankruptfirms
which deserve preliminarydiscussion.This matterwas alluded to in the
introduction.Realistic evaluation of a model's predictiverelationships
recuiresthat the predictorsare (would have been) available foruse prior
to the event of failure.Now, it is of course true that annual reportsare
not publicly available at the end of the fiscal year, since the financial
statementsmust be audited. Previous studies have not mentionedthis
problem,at least not explicitly.This is not surprisingsince most previous
studies have used Moody's Manual to derive the pertinentfinancial
ratios) and the Manual does not indicate at what point in time the data
were made available. Anotherreason is that not all studies have been
concernedwithstrictforecastingrelationships.That is, whetheraccountingstatementswere publiclyavailable or not had no directbearingupon
thesubject at hand. One such case is Beaver [1968a; 1968b],who studied
whetherfinancialratios will reflectimpendingfailure.The timingissue
canbe expected to be serious forfirmswhichhave a large probabilityof
failurein the firstplace. Such firmsare in poor shape and the auditing
process could be particularlyproblematicand timeconsuming.
Thus, it
is somewhat riskyto assume that financialreportswere available, say,
three monthsafterthe end of the fiscalyear. There are otherdisadvantages associated withMoody's Manual. The data are oftenhighlycondensed, and it is generallycomplicated,if not impossible,to reconstruct
actual balance sheets and income statements.5Again,firmswhich are in
poor shape are particularlydifficult,
since one can neverbe sure whether
some ofthemanypossiblespecial itemshave been givenspecial treatment
in Moody's tabulation.6Moreover,it should be noted that the comparative schedules over the different
years are expostreconstructions,
and
items fromprevious years may have been restatedand may differfrom
the amountsorigirialiv
reported.At a nontrivialcost,thisproblemcan be
circumventedifone uses several annual editionsofMoody's forthe same
firm.
Clearly,much can be gained by improvingthe data base. The evaluation of the predictive classificationpower of a model should be more
realistic,and, more importanthere, the same should apply forstandard
tests of statisticalsignificance.This is not to suggestthat it is important
to have "super accurate" data forpurposes of developing(as opposed to
evaluating) a discriminatorydevice. It mightwell be that the predictive
quality of any mode1 is reasonably robust across a variety of datagatheringand estimatingprocedures.
The conclusion is based oil a few"case studies."
The summaries of taxes (loss carryforward,
in particular)and measures of operating
performanceappear to be the most difficult
itemsto deal with.
6
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114
JAMES A. OHLSON
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115
TABLE
1
Bankrupt Firms: Year, Type ofBankruptcy,and Exchange Listing
Year
Type
Chapter X
.
Chapter XI
Other or unknown
Totals ...
.
.
1970
1971
1972
1973
1974
1975
1976
0
1
0
1
2
4
0
6
2
14
5
21
1
20
6
27
1
18
0
19
0
14
1
15
0
14
2
16
..
..........
Totals
6
85
14
105
.
8
43
54
19.
Funds statementshave been requiredsince September 30, 1971; see APB opinion No,
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116
JAMES A. OHLSON
Iq
LO~
LO~
ei
t
CI
oo
~~0 I~
I
C,
O
C
c1LC
ei
Cl1
Cl1
o
t
Co1
LO
I1
.4
Ci2
CO
C i2
4 0
Econ
00
; n
Dz *
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FINANCIAL
RATIOS
AND
BANKRUPTCY
117
can be quite long. In fact,for the group of eighteen firms,the lag was
always longerin the year whichwas closer to bankruptcy.The following
example is reasonably representative.Hers Apparel Ind. filedforbankruptcy May 31, 1974; the accountants' report for the fiscal yearend
February28, 1974 is dated July19, 1974. In the previousyear,the report
was dated April 24, 1973. Note that the lead time between fiscal year
date of last "relevant" reportand date of bankruptcyis approximately
thirteenmonthsin this case (i.e., April24, 1973 to May 31, 1974). In 1974,
it took approximatelyfourand onehalfmonthsto complete the audit.
(I found many cases which exceeded fourand onehalfmonths.) There
were also a numberof firmsforwhich additional relevantreportscould
have existed. Under such circumstances,search procedures were attempted,but with littlesuccess. For most of these cases, it appears as if
the firmssimplynever filedany additional reportswith the S.E.C. This
is by no means implausible,since firmscan apply forextensionof their
deadline, and afterbankruptcyhas actually occurredthere may simply
be no point in goingthroughan audit and preparinga standard annual
report.Of course, it is also possible that additional reportsdid exist,but
never got to the StanfordUniversityLibrary.In orderto play it "safe,"
I decided that no firmwas to be deleted because reportswere potentially
missing.As a consequence, any evaluation of a model based on this data
set probablyunderstatesthe predictiveclassificationperformance.
A sample ofnonbankruptfirmswas obtainedfromthe Compustattape.
Ideally, all reports for all firmssatisfyingthe population constraints
should have been includedas a controlsample. However,thiswas deemed
to be too costly and impractical (due to core memory constraints).I
decided instead that everyfirmon the Compustat tape (excludingutilities, etc.) should contributewithonly one vectorof data points;the year
of any givenfirm'sreportwas obtained by randomprocedure.This led to
2,058 vectors of data points fornonbankruptfirms.The breakdowninto
exchange listings was as follows: New York Stock Exchange = 42%,
American Stock Exchange = 32%, Other = 26%.
l(B3) ieS
ieS,
S2
is the set of
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118
JAMES
A. OHLSON
whereyi =
/,8Xij= f/'Xi.
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FINANCIAL
119
TLTA
CLCA
INTWO
Indeterminate
Negative
SIZE
WCTA
NITA
FUTL
CHIN
OENEG
Bankruptcy
Variable
SIZE .............
TLTA ..............
WCTA ..............
CLCA ...............
NITA ...............
FUTL
..............
INTWO
OENEG
.............
............
CHIN ...............
N .105
NonbankruptFirs
NnakptFrsruptcy
mean
stdv
mean
stdv
mean
stdv
12.134
0.905
0.041
1.32
0.208
0.117
1.38
0.637
0.608
2.52
0.411
0.421
13.26
0.488
0.310
0.525
0.0526
0.2806
1.570
0.181
0.182
0.740
0.0756
0.360
12.234
0.718
0.157
0.814
0.052
0.0096
1.414
0.311
0.320
0.671
0.155
0.332
0.390
0.18
0.488
0.385
0.0432
0.0044
0.2034
0.0660
0.180
0.060
0.384
0.237
0.322
0.644
0.0379
2,058
0.458
0.00308
0.8673
100
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120
JAMES
A. OHLSON
and ratios are not quite comparable with those of Beaver [1966], the
resultshere are quite similarto the profileshe presented[1966,p. 82]. It
should also be noted that the standard deviations of the predictors
(except for size) are larger for year1 firms,compared to nonbankrupt
firms.These differencesare significantat a 5percentlevel or better.
Hence, as discussed in Section 2, standard assumptions of MDA are
unlikelyto be valid.
Three sets of estimates were computed forthe logit model using the
predictorspreviouslydescribed.Model 1 predictsbankruptcywithinone
year; Model 2 predicts bankruptcywithin two years, given that the
company did not fail within the subsequent year; Model 3 predicts
bankruptcywithinone or two years.A summaryofthe resultsare shown
in table 4. This table indicates that all of the signswere as predictedfor
Model 1. Only three of the coefficients(WCTA, CLCA, and INTWO)
have tstatisticsless than two,so the othersare all statisticallysignificant
at a respectable level. This includesSIZE, whichhas a relativelylarge tis givenby the likelihood
statistic.An overall measure of goodnessoffit
ratio index. The index is similarto a R2 in the sense that it equals one in
are zero." For
case of a perfectfit,and zero ifthe estimatedcoefficients
Model 1, the ratio is 84 percent,and this is significantat an extremely
low alevel. The statistic "Percent CorrectlyPredicted" equals 96.12
percent;it is tabulated on the basis ofa cutoffpointof .5. That is, classify
the company if and only if P(XI., /) > 0.5. Whetherthis is a "good" or
"bad" result is not easy to answer at this stage, so furtherdiscussion
regardingthe model's predictivepoweris postponeduntilthe nextsection.
At thispoint,we can note that ifall firmswere classifiedas nonbankrupt,
then 91.15 percent would be correctlyclassified (2,058/(105 + 2,058)).
Thus the marginal(unconditional,prior)probabilityof bankruptcyis an
importantquantity in the above type of statistic.Further,there is no
apparent reason why .5 is an appropriatecutoffpoint,since it presumes
implicitlythat the loss functionis symmetricacross the two types of
classificationerrors.
Table 5 shows the correlationcoefficientsof the estimationerrorsin
ofthe financialstate variables (variables 14 in
Model 1. The coefficients
the table) are uncorrelated with those of the performancevariables
and
(variables 59). Hence, both sets ofvariables contributesignificantly
independentlyof each other to the likelihood function.This strongly
supports the contentionthat both sets of variables are importantin
establishingthe predictiverelationship.
Models 2 and 3 have somewhatweakergoodnessoffit
statistics,which
The likelihoodratio index is definedto be:
1  log likelihoodat convergence/loglikelihoodat zero.
The index will take on the value of one in case of a perfectfit,since log likelihood at
convergencethen equals zero. If there is no fit,then obviouslythe index equals zero. See
McFadden [1973] forfurtherdetails.
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FINANCIAL
c"
~~
c~~~o ~
Cq
U0~I
Cl~
CiclC~
CI
Cq
Cl1
UrCS
Lo
00
Cli
Cq
00
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lN
cI
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o
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m
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u0
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ro
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CZ
n
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121
Ho
C
lf
BANKRUPTCY
LO
CO
oo
't
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AND
RATIOS
l Lo lf
li
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e
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Q0~~~~~~~~~~~~~
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122
JAMES A. OHLSON
TABLE
5
CorrelationMatrix of (Estimated) Estimation Errors in Model 1
SIZE
SIZE .......
TLTA ......
WCTA
CLCA
OENEG
TLTA
WCTA
.28
1
.32
.49
CLCA
.46
NITA
FUTL
INTWO....
CHIN
* = Absolute
valueofcoefficient
lessthan.20.
OENEG
NITA
FUTL
INTWO
CHIN
.41
1
.40
*
.44
*
.32
1
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123
TABLE
6
Model 4
Variable
Estimates
SIZE ..........
.267
TLTA ...
5.63
.
WCTA .........
1.43
CLCA .. .........
.0585
NITA .......
2.35
FUTL
1.99
...........
INTWO .......
.307
1.56
OENEG .........
CHIN .....
. .
5092
NYSE ........
.854
AMSW
.0513
.......
CONST
2.63
..........
Percent CorrectlyPredicted
Likelihood Ratio Index
tStatistics
2.02
6.04
1.91
.595
1.82
2.53
.877
2.20
2.15
1.71
.186
1.70
96.30%
.8399
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124
JAMES
A. OHLSON
6. Evaluation of PredictivePerformance
There is no way one can completelyorderthe predictivepowerof a set
of models used for predictive(decision) purposes. As a minimum,this
requires a complete specificationof the decision problem,includinga
preferencestructuredefinedover the appropriatestatespace. Previous
work in the area of bankruptcypredictionhas generallybeen based on
two highlyspecificand restrictiveassumptionswhen predictiveperformance is evaluated. First,a (mis)classificationmatrixis assumed to be an
adequate partition of the payoffstructure.Second, the two types of
classificationerrorshave an additive property,and the "best" model is
one which minimizes the sums of percentage errors. Both of these
assumptions are arbitrary,although it must be admitted that the first
assumptionis of some value if one is to describeat least one implication
of using a model. Much of this discussionwill thereforefocus on such a
(mis)classificationdescription.Nevertheless,the second assumptionwill
also be used at some points,since it would otherwisebe impossibleto
compare the resultshere withthose of previousstudies.The comparison
cannot be across models because the time periods,predictors,and data
sets are different.Rather, the question of interestis one of findingto
what extentthe resultsconformwith each other.
Withoutloss ofgenerality,one may regardthe estimatedprobabilityof
failure,PMX1,fi),as a signal which classifiesfirmi into one of the two
groups.Hence, it is ofinterestto describethe conditionaldistributionsof
these signals. Figure 1 shows the empiricalfrequencyofP(X,, /3)forthe
105 firms which failed within a year; fiis the vector of estimated
coefficientsobtained fromModel 1. Figure2 shows the frequencyforthe
2,058nonfailedfirmswhere/3is again takenfromModel 1. Figure3 shows
the probabilitiesfor 100 firmstwo periods priorto bankruptcy;the /P's
Occurrence (percentage)
10.0
8.0
60
....
....
40
0. .
0
5.0.0.0
20
30
FI.
.irs
neyarprortobakupcy(15.irs
90
rooiltyofBnkupc
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FINANCIAL
Occurrence
RATIOS
AND
125
BANKRUPTCY
(percentage)
80
60
40
20
.10
.20
.30
.40
.50
.60
.70
80
90
I 00
Probability of Bankruptcy
1.0
I.
..
..
:..:
::::: ::::
_
,,:
...:.......
....m..
..
. ....,
..'.
05.. . . . . . . . .
..
.. O..
... ..
10
.40
.50
60
.70
.80
.90
1 00
Probabilityof Bankruptcy
were taken fromModel 2. The mean probabilitiesare .39, .03, and .20,
respectively.This is, ofcourse,in accordance withwhat one would expect
on the basis of priorreasoning.
Using the data which underlie figures13, one can readily perform
analysis of classificationerrorsfordifferent
cutoffpoints.The focuswill
be on a predictionof bankruptcywithinone year. A TypeI errorwill be
said to occur if P(X1, fi)is greaterthan the cutoffpoint and the firmi~s
nonbankrupt;in a similarfashion,one definesa TypeII errorforbankrupt firmsif the probabilityis less than the cutoffpoint. It would have
been preferableto performthe erroranalysis on a "fresh"data set and
thereby (in)validate the models estimnated.16
Due to the lack of data
beyond 1976,this was not possible at the time of the study.This should
not be a serious problem,however,forthe followingreasons.First,I have
'lbIt would, of course, have been possible to cut the sample in half and then go through
the usual kind of procedures. However, the primarypurpose of this paper is not one of
gettinga preciseevaluation ofa predictivemodel. Hence, it was decided thatthe fullsample
would be used in orderto produce the smallestpossible errorsofthe estimatedcoefficients.
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126
JAMES
A. OHLSON
Type I (percentage)
100r
FREQUENCY OF ERROR
80 
60
40
20
0
0
20
40
60
80
100
Type IT (percentage)
FIG. 4.
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FINANCIAL
RATIOS
AND
127
BANKRUPTCY
_80
Type I
Type II
60
40
20
60
40
20
20
40
60
80
100
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128
JAMES
A. OHLSON
". . .
bankruptcy classification
accuracy ranges fromover 96 (93% holdout) one period prior to bankruptcy"(Altmanet al. [1977,p. 50]). Needless to say, such resultsare not
in accordance withthose of the presentstudyor,forthat matter,the two
otherstudies whichused data fromthe seventies.I am unable to account
Altman et al. [1977] do not reporton
forthis difference.Unfortunately,
the average lead time,so it is impossible to evaluate the importanceof
thisfactor.Also, theydid not apply (or report)the predictiveperformance
of their recentZETA model on the 1974 sample. However, the authors
do seem to suggestsome sample dependence (see Altman et al. [1977, n.
16]). There are also differencesin the definitionof bankruptcy.
In sum, differencesin results are most difficultto reconcile. Moyer
[1977] recentlyreexaminedthe Altmanmodel using data fromthe 196575 period. (The Altman [1968] sample was from the 194665 period.) The
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FINANCIAL
RATIOS
AND
BANKRUPTCY
129
is more
improvementin goodnessoffit
previouslysuggested,a significant
likely to occur by augmentingthe accountingbaseddata with marketprice data.
At this point,I want to emphasize that the reportsof the misclassified
bankrupt firmsseem to lack any "warningsignals" of impedingbankruptcy.All but two of the thirteencompanies reporteda profit.The two
losses were relativelyminor(NITA was 0.022 and 0.044, respectively),
and these two companies had strongfinancialpositions (TLTA was .23
and .37, respectively).The median TLTA ratio is .55, and the range is
.23.70. The median NITA is 3.4 percentwitha range of 0.44 to 0.156.
(The firm which had TLTA = .70 had NITA = .156.) Other ratios
analyzed showed the same "healthy" patterns.It is not surprisingthat
these firmswere misclassified,especially if one considersthe profileof
the nonbankruptfirmsshown in table 3.
Moreover, the accountants' reportswould have been of little,if any,
use. None of the misclassifiedbankrupt firmshad a "goingconcern
qualification"or disclaimerof opinion.A reviewof the opinionsrevealed
that eleven of these companies had completelyclean opinions,and the
two that did not had relativelyminoruncertaintyexceptions.Curiously,
some of the firmseven paid dividends in the year priorto bankruptcy.
Hence, if any warningsignals were present,it is not clear what these
actually were.'
There is always the possibilitythat an alternativeestimatingtechnique,
other than the logit model used, could yield a more powerfuldiscrimia priorireasoningappears to be of no use
natorydevice. Unfortunately,
in findingsuch an "optimal" estimatingtechnique. All one can do is to
try some alternatives. One approach I tried, MDA, produced results
which were somewhat "worse" than those previouslyreported,in that
the minimumaverage errorrate was 16 percent.More generally,I would
hypothesizethat many"reasonable" procedureswilllead to resultswhich
will not differtoo much. This robustnesspropertycan be illustratedas
follows.Ifwe use the estimatesfromModel 2 forthe purposeofpredicting
bankruptcy within one year, the flestimatesfrom Model 2 will be
evaluated in terms of their predictivepower with respect to firmsone
year priorto bankruptcyand the 2,058 Compustatfirms.Again,different
cutoffpoints yield a tradeoffbetween the two types of errors.Table 7
displaysthe two typesof errorsat selected cutoffpointsforModels 1 and
2. Interestinglyenough, if a cutoffpoint of .08 is selected forModel 2,
then the average erroris 14.4 percent,and this is slightlybetterthan the
minimumattained by Model 1. Model 2 performsbetterat some other
18 Ratios other than those used in the estimatingequations were also examined. For all
of the misclassifiedfirms,I was unable to detect any ratio which was clearly out of line.
However,it is quite possible that a timeseriesanalysisofan extendedperiodwould indicate
thatsome ofthe firmshad "significant"aboveaverageoperatingrisks.By the use ofmarket
data, this problemwill be investigatedin the future.
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JAMES
130
A. OHLSON
TABLE
Model 1
Type I**
Type II
Type I
Model 2
Type II
0%
7.6
14.3
20.0
25.7
26.7
44.8
48.6
57.1
61.0
67.6
68.6
71.4
76.2
81.9
88.6
1.00
100%
54.3
37.7
26.8
20.2
17.0
7.2
3.6
2.0
1.75
1.07
0.82
0.68
0.49
0.24
0.19
0
0%
0%
0.95
4.76
8.6
12.4
31.4
43.8
50.5
51.4
57.1
61.0
62.9
70.5
74.3
82.9
1.00
100%
28.7
16.7
11.8
9.3
7.2
3.3
1.75
1.07
0.92
0.63
0.44
0.29
0.19
0.15
0.049
0
points too; that is, fora fixedlevel of one type of errorforboth models,
the complementaryerroris lower for Model 2. A close examinationof
table 7 will verifythis. To be sure,forsome errorrates Model 1 is better
than Model 2. It seems reasonable to suggest that the models are
essentiallyequivalent as predictivetools.
7. Conclusions
There are two conclusionswhich should be restated.First,the predictive power of any model depends upon when the information(financial
report)is assumed to be available. Some previousstudies have not been
carefulin this regard.Second, the predictivepowersof linear transforms
of a vector of ratios seem to be robust across (large sample) estimation
procedures. Hence, more than anythingelse, significantimprovement
probablyrequires additional predictors.
REFERENCES
E. "Financial Ratios, DiscriminantAnalysis and the Prediction of Corporate
Bankruptcy."Journal of Finance (September 1968).
. Corporate Bankruptcyin America. Lexington,Mass.: Heath Lexington,1971.
. "PredictingRailroad Bankruptciesin America." Bell Journal of Economics and
Management Science (Spring 1973).
, R. HALDEMAN, AND P. NARAYANAN. "ZETA Analysis:A New Model to Identify
BankruptcyRisk of Corporations."Journal ofBanking and Finance (June 1977).
Broker
, AND B. LORRIS. "A Financial Early WarningSystem forOvertheCounter
Dealers." Journal of Finance (September 1976).
ALTMAN,
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FINANCIAL
RATIOS
AND
BANKRUPTCY
131
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