Financial Ratios as Predictors of Failure: Evidence from ... - ERIM

size, financial structure, performance 10 , and current liquidity.
In their empirical analysis, Westgaard and Wijst (2001) used the 1996 accounting data
and the 1998 bankruptcy information (2-year prior to default) and illustrated that
financial ratios (cash flow to debt, financial coverage, liquidity, and equity ratio) were
negatively and significantly correlated with PD in a corporate bank portfolio in Norway.
One year later, Westgaard and Wijst together with Hol (2002) did another research for
Norwegian limited liability companies, but with different proxy variables and time
horizon (1995-2000). Their main finding was that leverage and cash flow standard
deviation had a significantly positive effect on default probability, while cash flow had a
significant negative effect. Similarly, Zeitun et al (2007) proved that firms’ cash flow
decreased corporate failure in Jordanian companies. Their main contribution, however,
was that they addressed the issue of free cash flow 11 and default risk. They concluded
that firms’ PD increased with firms’ free cash flow, which also seemed to be consistent
with agency theory. The predictive power of their models (three years prior to default) for
both matched and non-matched is very high (91.5%, 80%, and 81%). A summary of the
previous researches is presented in Table One in Appendix One.
4. Data and Methodology
4.1 Methodology
Multiple Discriminant Analysis has been widely used in default research. Nevertheless
the usefulness of MDA is quite limited, since such a technique only provides qualitative
differentiation among counterparties, and does not produce probabilities. Furthermore,
10 Measured as net income to total assets
11 Free cash flow was measured as retained earning to total assets (also see Dhumale, 1998).
11