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

Beaver (1966), Marais (1979), Altman and Lavallee (1981) and Westgaard and Wijst
(2001) and others). Nevertheless, there has been little similar bankruptcy research in Asia.
One possible explanation could be that Asian financial markets just emerged in the last
decade, whereas most of the default analyses were conducted over 20 years ago. So far
there has been no comprehensive bankruptcy analysis performed in the context of Hong
Kong. However, being one of the first banking industries who adopted the new banking
regulation, Hong Kong deserves extra attention. Compared to most empirical studies in
the 70s and 80s, the data set used in this research (from 2001 to 2007) is rather
contemporary. Therefore, whether previous empirical results still stand in a modern
context is under question.
The rest of the paper is structured as follows. In the next section, I briefly introduce
probability of default and bankruptcy. Section 3 reviews literature. In section 4, I explain
the data, sample selection, and methodology used in the analysis. Section 5 presents the
empirical results. Section 6 concludes.
2. Probability of Default and Bankruptcy
Legally speaking, bankruptcy is described as a debtor not being able to meet its debt
obligations as they fall due. In an accounting sense, when the sum of the realized cash
flow and expected future cash flow is less than the debt obligations, bankruptcy occurs.
PD is used to measure the likelihood that a firm defaults under its debt obligations.
Different researchers have different definitions of failure 2 . Operationally, Beaver (1968
(1)) defined a failed firm when any of the following events has occurred: bankruptcies,
bond default, overdrawn bank account, or nonpayment of a preferred stock dividend.
2
See a summary of the definitions of failure in major empirical default analyses, by Castagna and Matolcsy
(1981)
5