LITERATURE REVIEW

Forecasting Bankruptcy

Literature Review

Forecasting Bankruptcy

The ability to predict bankruptcy is critical for many users of financial statements. Such users include banks, investors, credit rating agencies, underwriters, auditors and regulators .During a period of financial and economic crisis, the importance of using a model to predict bankruptcy and flag warning signs as early as possible becomes increasingly important. Thus, for example, it is important for institutional investors who are buying corporate bonds to know the risk of bankruptcy inherent in said bonds, both prior and subsequent to their purchase. (Aretz, 2012)

One of the prominent models for forecasting bankruptcy is Edward Altman's Survival Model. Altman's studies showed that poor management of a firm (as reflected in the financial ratios) and not necessarily fierce competition and economic recession is the main cause of bankruptcy. Using the model, it is possible to predict early warning signs of potential collapse. Altman compared two groups of firms: bankrupt and non-bankrupt firms(Anginer, 2010). The model examined a large number of financial ratios to forecast the company's risk of financial failure, and the five best were selected to predict bankruptcy. Each ratio received a different weight based on its relative contribution to assessing the stability of the company. In 1968, the accuracy of the Altman Model in predicting bankrupt firms was estimated at 95% one year prior to bankruptcy and 72% two years prior to bankruptcy.Altman was the first to use multi-variable models to predict bankruptcy (Crosbie, 2003)

In his influential 1968 research, he analyzed financial ratios of bankrupt and stable firms. He used a combination of financial ratios to predict bankruptcy. The inherent advantage of his model is a combination of the typical attributes of the relevant firm, while examining the common impacts of the variables, in contrast to Beaver's Model, which examined each ratio separately(Griffin, 2002).

Altman examined the various financial ratios related to liquidity, profitability, financial leverage, activity and solvency. He used a discriminate ratio model, where the dependent variable is classified in one of two groups -bankrupt firms and non-bankrupt firms, and the model provides coefficients for the explanatory variables, according to the discriminating ability of the variables. Of the numerous financial ratios examined, five (X1 through X5) that significantly contributed to forecasting. Each ratio is assigned a coefficient (weight) based on its relative contribution(Chava & Amiyatosh, 2010). The index - the Z-score - comprises the multiplication of each of the ratios by the appropriate coefficient and addition of the results. The model, which has become standard, showed high predictive power regarding which companies could face financial distress.Over the past decade, the Z-score models were used as a proxy for bankruptcy risks in such areas as strategic planning, investment decisions, asset pricing, capital structure, credit risk pricing, distressed securities and going-concern research(O'Doherty, 2010).

According to Shumway, (2001) Economists and accountants have been forecasting bankruptcy for decades (see Altman 1993 for a survey). Most researchers have estimated single period classification models with multiple-period bankruptcy data.

According to Shumway, (2001) Static models are inappropriate for forecasting bankruptcy because of the ...