An analysis of the discriminant corporate failure prediction model based on stability of financial ratios
Abstract
The objectives of this study were to develop a discriminant model incorporating financial
ratio stability that can be used to predict corporate failure, to identify critical financial
ratios with significant predictive ability and to measure the improvement in the predictive
ability achieved by incorporating a measure of stability of financial ratios to the
discriminant failure model. The study, which covered the period between 1992 to 2000,
was based on 20 companies; 10 failed and 10 non-failed. A failure prediction model that
discriminates between failed and non-failed companies was developed using ratios alone and subsequently incorporating ratio stability using the standard deviation of the ratios.
The findings show that it is possible to predict corporate failure with up to 70 percent
accuracy three years before its occurrence, using ratio stability discriminant model.
Further validation of the findings suggest that the predictive accuracy was significantly
better than chance. Net profit/Sales, Net profit/Total Assets, Current Debt/Inventory, and
Total Debt/Total Assets were identified as critical financial ratios in predicting corporate
failure. In general the liquidity, profitability and leverage ratios were found to be
significant in company failure prediction. The ability of a firm to meet both short-term
and long-term obligations was a key indicator of a company's failure path.
Citation
Degree Of Master Of Business Administration, Faculty Of Commerce, University Of Nairobi, 2003Publisher
University of Nairobi Department of Business Administration