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

More documents

Recommendations

Info

financial ratios can be used to predict PD. 3.1 Theories In a world without tax and bankruptcy, there is no optimal capital structure under the classic Modigliani-Miller irrelevance theorem 6 (Modigliani & Miller 1958, 1963). Nevertheless, in the real world, most companies have to choose between tax advantages and bankruptcy costs (trade-off theory, Kraus and Litzenberger, 1973). That is, debt brings tax shields for a company, but at the same time it increases distress or bankruptcy costs. The optimal amount of debt should produce the lowest weighted average cost of capital. Kim (1978) claimed that the market value of a company decreases as financial leverage becomes extreme, thus it should finance less debt than its debt capacity (the optimum 7 ). The transfer of ownership from shareholders to debtholders also encourages risk taking behavior, because shareholders have the limited downside risk while enjoying unlimited upside potential, further reinforcing the conflict of interests between various stakeholders in the company. Therefore, higher debt in one’s capital structure should be associated with higher PD. From external to internal financing, cash flow has been an important determinant of bankruptcy. Scott (1981) claimed that cash flow variables involve estimates of the firm’s future cash flow distribution, and that past and present cash flow should be able to predict PD. Financial Accounting Standards Board (1981) stated that “the greater the amount of future net cash inflows from operations, the greater the ability of the enterprise to withstand adverse changes in operating conditions”. Other scholars have also shown 6 The total value of a firm will not change because of its capital structure. In other words, no capital structure is better or worse than any other capital structure for the firm’s shareholders. 7 The breakeven point is where the marginal benefit of the tax shield equals the marginal cost of financial distress. 7
interest in predicting bankruptcy by incorporating cash flow characteristics in their predictive models (see e.g. Casey and Bartczak (1985), Gentry et al (1985), Gombola et al (1987), and Aziz (1988), among others). Cash rich companies are assumed to be better able to diversify their risks and therefore less likely to go bankrupt. Deakin (1972) used several cash flow ratios (cash flow/total debt, cash/total assets, cash/current liabilities, cash/sales) to test their coefficients with bankruptcy. The signs of the coefficients were negative but did not seem to be consistent in all five years before companies’ bankruptcies. Recently, Zeitun et al (2007) demonstrated the negative relationship between cash flow and default risk, however the results were not significant. Similar to cash flow, a shortage of liquidity could also trigger corporate failure. Cash, the most liquid form of assets is crucial to a company disregarding its size or industry type. Furthermore, it also matters how quickly a company is able to covert other assets into cash with no or little price discount. Therefore, the availability and convertibility of a company’s assets are extremely important especially in crises. Becchetti and Sierra (2003), among others used liquidity ratios for their bankruptcy analyses. There are always trade-offs between internal and external financing. According to the pecking order theory (Myers, 1984), a company should use relatively costless internal financing over external financing. However internal financing is not without problem. If a company’s cash flow cannot be distributed to its shareholders or debtholders, managers are more likely to misuse retained earnings. Internal financing better sources free cash flow (measured as operating cash flow minus the capital expenditures) and thereby increases agency costs (Jensen, 1986) due to the asymmetric information between managers and shareholders. A high level of free cash flow seems to destroy corporate value, so it is expected to be positively related to bankruptcy. Changes in market prices of stocks can also be used to predict failure (Beaver 1968 (2), 8
Page 1 and 2: 17 Nov 2008 Financial Ratios as Pre
Page 3 and 4: Abstract This paper presents some e
Page 5 and 6: 1. Introduction One year after the
Page 7: However he did not find substantial
Page 11 and 12: atios he employed in the research w
Page 13 and 14: there are specific statistical requ
Page 15 and 16: “returns”, “values” and “
Page 17 and 18: Table 2 Explanatory Variables Varia
Page 19 and 20: which results in high standard erro
Page 21 and 22: Table 7 Variables in the Equation (
Page 23 and 24: Summary. -2 log likelihood (-2LL) i
Page 25 and 26: predicted to be default, it is call
Page 27 and 28: estimation procedure. However it is
Page 29 and 30: Ohlson (1980)). In the second sampl
Page 31 and 32: Reference Altman, E. I., 1968, “F
Page 33 and 34: Hong Kong Society of Accountants, 1
Page 35 and 36: MDA Appendix One Table 1 Literature
Page 37 and 38: Appendix Two Table 4 Descriptive St
Page 39 and 40: Appendix Four Table 9 Coefficients
Page 41 and 42: Appendix Six Table 10 Coefficients
Page 43 and 44: Appendix Eight Table 12 Classificat

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

You also want an ePaper? Increase the reach of your titles

Delete template?

Save as template?