Predicting Corporate Bankruptcy: Analysis of Financial Vital Signs

For this assignment you will find an attached case (below) which you are required to analyze and present your analysis in a formal report. This is a group project which will be due on the second to last day of the intensive at 5 PM. (January 11, 2022). The group will consist of 2-3 students and you will find a group sign up sheet located on the assignment page and the front page of your course site.

It will be the choice of the students whether to submit this assignment online or in person, either submission will be accepted.

What sort of formal report are we looking for? Assume you are newly hired members of the Risk Division of your financial institution. The chief Risk officer has asked you to review this data and present it back in a formal report. The final format of the report is up to you. I have included a sample table of contents from another formal report that you may use as a guideline as to the content of the report. The rough guide as to the length of this paper is 7 pages not including appendices.

The data for this report can be found in the Excel sheet entitled ‘QDM Report Data.xls’.

Just as doctors check blood pressure and pulse rate as vital indicators of the health of a patient, so business analysts scour the financial statements of a corporation to monitor its financial health. Whereas blood pressure, pulse rate, and most medical vital signs, however, are measured through precisely defined procedures, financial variables are recorded under much less specific general principles of accounting. A primary issue in financial analysis, then, is: how predictable is the health of a company?

One difficulty in analyzing financial report information is the lack of disclosure of actual cash receipts and disbursements. Users of financial statements have had to rely on proxies for cash flow, perhaps the simplest of which is income (INC) or earnings per share. Attempts to improve INC as a proxy for cash flow include using income plus depreciation (INCDEP), working capital from operations (WCFO), and cash flow from operations (CFFO). CFFO is obtained by adjusting income from operations for all non-cash expenditures and revenues and for changes in the current asset and current liabilities accounts.

A further difficulty in interpreting historical financial disclosure information is caused whenever major changes are made in accounting standards. For example, the Financial Accounting Standards Board issued several promulgations in the middle 1970s that changed the requirements for reporting accruals pertaining to such things as equity earnings, foreign currency gain and losses, and deferred taxes. One effect of changes of this sort was that earnings figures became less reliable indicators of cash flow.

Formal Report Analysis Requirements

In the light of these difficulties in interpreting accounting information, just what are the important vital signs of corporate health? Is cash flow an important signal? if not, what is? If so, what is the best way to approximate cash flow? How can we predict the impending demise of a company?

To begin to answer some of these important Questions, we conducted a study of the financial vital signs of bankrupt and healthy companies. We first identified 66 failed firms from a list provided by Dun and Bradstreet. These firms were in manufacturing or retailing and had financial data available on the Compustat Research tape. Bankruptcy occurred somewhere between 1970 and 1982.

For each of these 66 failed firms, we selected a healthy firm of approximately the same size (as measured by the book value of the firm's assets) from the same industry (3-digit SIC code) as a basis of comparison. This matched-sample technique was used to minimize the impact of any extraneous factors (such as industry) on the conclusions of the study.

The study was designed to see how well bankruptcy can be predicted two years in advance. A total of 24 financial ratios were computed for each of the 132 firms using data from the Compustat tapes and from Moody's Industrial Manutil for the year that was two years prior to the year of bankruptcy. Exhibit 1 lists the 24 ratios together with an explanation of the abbreviations used for the fundamental financial variables. All these variables are contained in a firm's annual report with the exception of CFFO. Ratios were used to facilitate comparisons across firms of various sizes.

The first four ratios using CASH in the numerator might be thought of as measures of a firm's cash reservoir with which to pay debts. The three ratios with CURASS in the numerator capture the firm's generation of current assets with which to pay debts. Two ratios, CURDEBT/DEBT and ASSETS/DEBTS, measure the firm's debt structure. Inventory and receivables turnover are measured by COGS/INV and SALES/REC, and SALES/ASSETS measures the firm's ability to generate sales. The final 12 ratios are asset-flow measures.

Exhibit 2 gives the 24 ratios for 50 of the 66 matched pairs of firms. Also included in this data base is the year of bankruptcy for the failed firm in the matched pair and a dummy variable denoting either a failed firm with a 0 or a healthy firm with a 1.

Exhibit 3 shows the 24 ratios for 16 matched pairs of firms held out to test the ability of these financial ratios to predict bankruptcy. Comparing the 50 failed firms with the 50 healthy firms in Exhibit 1, what are the distinguishing characteristics of the two sets? Is it possible to develop a procedure for distinguishing healthy firms from firms about to go bankrupt? Which ratio is the best measure of corporate health? Which combination of ratios should be used to predict bankruptcy? Which of the 32 firms in Exhibit 3 would you predict went bankrupt?