Skip to main content Accessibility help
×
Home

Taking the Twists into Account: Predicting Firm Bankruptcy Risk with Splines of Financial Ratios

  • Paolo Giordani (a1), Tor Jacobson (a2), Erik von Schedvin (a3) and Mattias Villani (a4)

Abstract

We demonstrate improvements in predictive power when introducing spline functions to take account of highly nonlinear relationships between firm failure and leverage, earnings, and liquidity in a logistic bankruptcy model. Our results show that modeling excessive nonlinearities yields substantially improved bankruptcy predictions, on the order of 70%–90%, compared with a standard logistic model. The spline model provides several important and surprising insights into nonmonotonic bankruptcy relationships. We find that low-leveraged as well as highly profitable firms are riskier than those given by a standard model, possibly a manifestation of credit rationing and excess cash-flow volatility.

Copyright

References

Hide All
Agarwal, R., and Gort, M.. “The Evolution of Markets and Entry, Exit and Survival of Firms.” Review of Economics and Statistics, 78 (1996), 489498.
Almeida, H.; Campello, M.; and Weisbach, M.. “The Cash Flow Sensitivity of Cash.” Journal of Finance, 59 (2004), 17771804.
Altman, E. “Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy.” Journal of Finance, 23 (1968), 589611.
Altman, E. “Railroad Bankruptcy Propensity.” Journal of Finance, 26 (1971), 333345.
Altman, E. “The Success of Business Failure Prediction Models.” Journal of Banking and Finance, 8 (1984), 171198.
Altman, E. “Predicting Financial Distress of Companies: Revisiting the Z-Score and Zeta Models.” Working Paper, New York University (2000).
Altman, E., and Narayanan, P.. “An International Survey of Business Failure Classification Models.” Financial Markets, Institutions & Instruments, 6 (1997), 157.
Altman, E., and Saunders, A.. “Credit Risk Measurement: Developments over the Last Twenty Years.” Journal of Banking and Finance, 21 (1997), 17211742.
Beaver, W. “Financial Ratios as Predictors of Failure.” Journal of Accounting Research, 4 (1966), 71111.
Berg, D. “Bankruptcy Prediction by Generalized Additive Models.” Applied Stochastic Models in Business and Industry, 23 (2007), 129143.
Bharath, S., and Shumway, T.. “Forecasting Default with the Merton Distance to Default Model.” Review of Financial Studies, 21 (2008), 13391369.
Campbell, J.; Hilscher, J.; and Szilagyi, J.. “In Search of Distress Risk.” Journal of Finance, 63 (2008), 28992939.
Chava, S., and Jarrow, R.. “Bankruptcy Prediction with Industry Effects.” Review of Finance, 8 (2004), 537569.
Dakovic, R.; Czado, C.; and Berg, D.. “Bankruptcy Prediction in Norway: A Comparison Study.” Applied Economics Letters, 17 (2010), 17391746.
Denison, D.; Mallick, B.; and Smith, A.. “Bayesian Methods for Nonlinear Classification and Regression.” Chicester, UK: John Wiley & Sons (2003).
Hastie, T., and Tibshirani, R.. Generalized Additive Models. Boca Raton, FL: Chapman & Hall (1990).
Hastie, T.; Tibshirani, R.; and Friedman, J.. The Elements of Statistical Learning, 2nd ed., Springer Series in Statistics. New York: Springer (2009).
Hosmer, D., and Lemeshow, S.. Applied Logistic Regression, 2nd ed. New York: Wiley (2000).
Jacobson, T.; Lindé, J.; and Roszbach, K.. “Firm Default and Aggregate Fluctuations.” Journal of the European Economic Association, 11 (2013), 945972.
Jensen, M. “Agency Costs of Free Cash Flow, Corporate Finance and Takeovers.” American Economic Review, 76 (1986), 323329.
Jovanovic, B. “Selection and the Evolution of Industry.” Econometrica, 50 (1982), 649670.
Lang, L.; Poulsen, A.; and Stulz, R.. “Asset Sales, Firm Performance, and the Agency Costs of Managerial Discretion.” Journal of Financial Economics, 37 (1995), 337.
Li, Q., and Racine, J.. Nonparametric Econometrics: Theory and Practice. Princeton, NJ: Princeton University Press (2007).
McFadden, D. “The Measurement of Urban Travel Demand.” Journal of Public Economics, 3 (1974), 303328.
Merton, R. “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates.” Journal of Finance, 29 (1974), 449470.
Minton, B., and Schrand, C.. “The Impact of Cash Flow Volatility on Discretionary Investment and the Costs of Debt and Equity Financing.” Journal of Financial Economics, 54 (1999), 423460.
Nance, D.; Smith, C. Jr.; and Smithson, C.. “On the Determinants of Corporate Hedging.” Journal of Finance, 48 (1993), 267284.
Ohlson, J. “Financial Ratios and the Probabilistic Prediction of Bankruptcy.” Journal of Accounting Research, 18 (1980), 109131.
Opler, T.; Pinkowitz, L.; Stulz, R.; and Williamson, R.. “The Determinants and Implications of Corporate Cash Holdings.” Journal of Financial Economics, 52 (1999), 346.
Ruppert, D.; Wand, M.; and Carroll, R.. Semiparametric Regression. Cambridge, UK: Cambridge University Press (2003).
Schwarz, G. “Estimating the Dimension of a Model.” Annals of Statistics, 6 (1978), 461464.
Shumway, T. “Forecasting Bankruptcy More Accurately: A Simple Hazard Model.” Journal of Business, 74 (2001), 101124.
Smith, M., and Kohn, R.. “Nonparametric Regression Using Bayesian Variable Selection.” Journal of Econometrics, 75 (1996), 317343.
Stiglitz, J., and Weiss, A.. “Credit Rationing in Markets with Imperfect Information.” American Economic Review, 71 (1981), 393410.
Zmijewski, M. “Methodological Issues Related to the Estimation of Financial Distress Prediction Models.” Journal of Accounting Research, 22 (1984), 5982.

Taking the Twists into Account: Predicting Firm Bankruptcy Risk with Splines of Financial Ratios

  • Paolo Giordani (a1), Tor Jacobson (a2), Erik von Schedvin (a3) and Mattias Villani (a4)

Metrics

Full text views

Total number of HTML views: 0
Total number of PDF views: 0 *
Loading metrics...

Abstract views

Total abstract views: 0 *
Loading metrics...

* Views captured on Cambridge Core between <date>. This data will be updated every 24 hours.

Usage data cannot currently be displayed