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Financial Ratios And The Probabilistic Prediction Of Bankruptcy

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Question:

Discuss about the Financial Ratios and the Probabilistic Prediction of Bankruptcy.
 
 

Answer:

Introduction:

Auditors are responsible and have a fiduciary obligation to provide an opinion regarding going concern opinion to an entity. The going-concern is considered to be vital indication whether the company is in a position to provide continuing performance in the future years. For this aspect, there are various tools that can use by auditors for the assessment of going concern status of the company. In accordance with GAAP (generally accepted accounting principles), the assumption of the going concern is essential for the preparation of financial statements (Wang and Lin, 2013). Ohlson (1980) in the US, was the first research scholar to apply logistic regression analysis to analyse going concern status of the company which is still considered to be viable for auditing. Olson had made use of 105 bankrupt and 2058 non-bankrupt firms in his study during the period of 1970-1976. Ohlson (1980) had a number of the predictors for development of his model to ensure accurate results. These predictors were considered by refereeing to recurrently mentioned parameters in the literature. For deriving his bankruptcy prediction model, he had applied logical analysis by using nine measures of firms related to its size, liquidity, leverage, and performance. His model was

Y = -1.3 - .4 Y1 + 6.0 Y2 - 1.4 Y3 + .1 Y4 -2.4 Y5 - 1.8 Y6 + .3Y7 -1.7 Y8 - .5Y9 (2)

In this model:

  • Y1 = log (Total assets / GNP price-level index);
  • Y2 = Total liabilities / Total assets;
  • Y3 = Working capital / Total assets;
  • Y4 = Current liabilities / Current assets;
  • Y5 = In case where total liabilities surpass total assets, else this value is considered to be 0
  • Y6 = Net income of financial year / Total assets;
  • Y7 = Funds generated through operational activities / Total liabilities;
  • Y8 = In case where net income is negative for past two years, else this value is considered to be 0
  • Y9 = Measure of variation in the net income;
  • Y = overall index.

The model developed by Ohlson (1980) shows that leverage has substantial ability forecasting towards the corporate financial distress. In the case where there are issues in capital dispatch, then there will the high probability of debt crash, thus higher delist possibility will exist. For evaluation of going concern, this model is viable as it considers all the negative trends through which auditor get well versed with the indications related to financial problems considering internal as well as external matters. With the applicability of this model, audit firm will provide opinion on the company by considering its overall position in order to provide a true and fair view to stakeholders so they can make their decisions rationally. In addition to this, auditing firm will be in position to point out material risk factors that can create threat to going concern in the near future.

 

References

Ohlson, J A., 1980.  “Financial Ratios and the Probabilistic Prediction of Bankruptcy,” Journal of Accounting Research. Pp. 109-131.

Wang, C. C., Y. J. Lin, & Y. S. Hsu. 2013. The initial going-concern of delisting firms: An application of proportional hazard model. Journal of finance & Accounting, 5, 139-158.

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