Financial Crisis Prediction Capability of Financial Ratios

Abstract

Bankruptcy of a business firm is an event which results substantial losses to creditors and stockholders. A model which is capable of predicting an upcoming business failure will serve as a very useful tool to reduce such losses by providing warning to the interested parties. This was the main motivation for Beaver (1966) and Altman (1968) to construct bankruptcy prediction models based on the financial data (Deakin 1972).
This research study also initiated with a great interest on this subject to investigate the predictive capability of financial ratios for forecasting of corporate distress and bankruptcy events.

The current global financial climate demands even the best international companies to constantly monitor their financial situation and their related companies with which they cooperate. Globalization process has delivered a complex network of relationships in the business environment. Due to increase in complexity of related business environment, forecasting the financial health of companies nowadays became increasingly important and worthwhile to analyse (Korol 2013). Bankruptcy is a continuous process, which can be distinguished into several stages, starting from the emergence of the first signs of financial crisis, through blindness and ignorance towards the financial and nonfinancial symptoms of crisis in a firm, to inappropriate activities that lead to the final phase of the crisis, which is bankruptcy. The Bankruptcy process cycle may take up to 5–6 years which is not a sudden phenomenon and impossible to predict, however the earlier warning signals can be detected and corrective measures may avoid the ultimate bankruptcy event depending on the preparation and reactions of the management to tackle the bankruptcy (Korol 2013). Due to the recent worldwide corporate financial crisis the need to reform the existing financial architecture has been intensified. Objective of business crisis prediction is to build models that can read the risk factors from the past observations and evaluate business crisis risk of companies with a much broader scope (Lin et al. 2011).

Ozkan cited in Lin et al. 2011 mentioned that financial indicators has been reviewed by number of researchers as a major basis for predicting financial distress and some common methodologies including peer group analysis, comprehensive risk assessment systems, and statistical and econometric analysis. Premachandra (2009) argued that bankruptcy prediction is important because corporate failure imposes significant direct and indirect costs on stakeholders. Warner cited in Premachandra (2009), evidence suggests that direct bankruptcy costs (such as court costs, lawyers and accountants fees) may be as low as 5%, or (Altman cited in Premachandra 2009) can shoot up to 28% when both direct and indirect costs (such as lost sales, lost profits, higher cost of credit, inability to issue new securities and lost investment opportunities) are considered. Therefore the early detection of potential bankruptcy is very important due to corporate decision makers make their decisions in a world of dynamic technology development, imperfect knowledge and uncertainty (Premachandra 2009).

Niewrzedowski cited in Korol (2013) indicated that as per statistical analysis by Huler-Hermes, the number of potential bankruptcy has been increased in USA by 54%, in Spain by 118% and in the UK by 56%. Therefore the importance of early warning of potential bankruptcy has been increased along with the overall increase of bankruptcy risk in companies around the world.