CORPORATE BANKRUPTCY CAN BE PREDICTED OR PREVENTED

Corporate Bankruptcy Can Be Predicted or Prevented



Abstract

The focus of this paper will be on the bankruptcy prediction of small firms. Specifically, two successful bankruptcy prediction models, Ohlson's model (1980) and Shumway's model (2001), will be re-estimated with the data of a sample of firms traded on the over-the-counter (OTC) market in a recent period in the 1990s. While Ohlson's model relies strictly on accounting ratios, Shumway's model combines market measures with the accounting ratios. Both models will be then validated by a classification test and a more rigorous prediction test to predict the bankruptcy probability of the holdout samples.

Corporate Bankruptcy Can Be Predicted or Prevented

Introduction

Business failures will be considered both unfortunate and costly at least by the owners, creditors, employees, suppliers and customers of the failed firms. Even the ardent admirers of the market mechanisms' ability to increase efficiency through its "survival of the fittest" principle find the social and economic consequences of business failures rather unpleasant in the short run. Accordingly, for over thirty years, academic researchers and practitioners in the fields of accounting, economics and finance have shown a strong and determined interest in developing and testing business failure prediction models.

The literature on bankruptcy prediction models will be rich and it demonstrates numerous strides made over the years since the pioneering research by Beaver (1966). Small firms also account for about half of the private sector employment and create two of every three new jobs. The crucial importance of small firms in the business frontier provides partial impetus for this study. The relative paucity of studies focusing on small business failure provides additional motivation for the present study.

Objective of Study

The objective of the empirical investigation in this study will be to examine the effectiveness of two highly successful bankruptcy prediction models, namely, Ohlson's model (1980) and Shumway's model (2001) in predicting bankruptcy of small firms. Specifically, this study applies the two models for predicting bankruptcy of a sample of over-the-counter (OTC) traded firms during a period of the 1990s. While Ohlson's model relies strictly on accounting data, Shumway's model combines market information with the accounting data.

Research Question

Whether models that have been used successfully to predict bankruptcy for very large firms can be used effectively to predict bankruptcy for small firms?

Summary

A brief review of the literature will be the subject of the second section. The methodology and the data adopted in this study will be explained in the third section. The empirical results will be presented and analyzed in the fourth section. A summary of the paper makes up the final section.

Literature Review

Since the seminal work of Beaver (1966), financial ratio analysis has become the favorite approach to investigating the bankruptcy problem (Altman, 1993). Numerous studies have been published through the development of various statistical techniques into ratio analysis to predict bankruptcy over the past thirty years. Empirical research for predicting bankruptcy started with univariate analysis (e.g., Beaver, 1966). Under this method, each individual ratio will be examined ...