Journal of Finance2014-09-28 4:51 PM

FINANCIAL RATIOS, DISCRIMINANT ANALYSIS AND THE PREDICTION OF CORPORATE BANKRUPTCY

Abstract

ACADEMICIANS SEEM to be moving toward the elimination of ratio analysis as an analytical technique in assessing the performance of the business enterprise. Theorists downgrade arbitrary rules of thumb, such as company ratio comparisons, widely used by practitioners. Since attacks on the relevance of ratio analysis emanate from many esteemed members of the scholarly world, does this mean that ratio analysis is limited to the world of “nuts and bolts”? Or, has the significance of such an approach been unattractively garbed and therefore unfairly handicapped? Can we bridge the gap, rather than sever the link, between traditional ratio “analysis” and the more rigorous statistical techniques which have become popular among academicians in recent years?

The purpose of this paper is to attempt an assessment of this issue —the quality of ratio analysis as an analytical technique. The prediction of corporate bankruptcy is used as an illustrative case.1 Specifically, a set of financial and economic ratios will be investigated in a bankruptcy prediction context wherein a multiple discriminant statistical methodology is employed. The data used in the study are limited to manufacturing corporations.

A brief review of the development of traditional ratio analysis as a technique for investigating corporate performance is presented in section I. In section II the shortcomings of this approach are discussed and multiple discriminant analysis is introduced with the emphasis centering on its compatibility with ratio analysis in a bankruptcy prediction context. The discriminant model is developed in section III, where an initial sample of sixty-six firms is utilized to establish a function which best discriminates between companies in two mutually exclusive groups: bankrupt and non-bankrupt firms. Section IV reviews empirical results obtained from the initial sample and several secondary samples, the latter being selected to examine the reliability of the discriminant model as a predictive technique. In section V the model's adaptability to practical decision-making situations and its potential benefits in a variety of situations are suggested. The final section summarizes the findings and conclusions of the study, and assesses the role and significance of traditional ratio analysis within a modern analytical context.


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Journal of Finance

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