Financial Ratios, Discriminant Analysis and the Prediction of Corporat

The article Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy was written in 1968 by Edward I. Altman. The purpose of the article is to address the quality of ratio analysis as an analytical technique. At the time some academicians were moving away from ratio analysis and moving toward statistical analysis. The article attempted to determine if ratio analysis should be continued, eliminated and replaced by statistical analysis or serve together with statistical analysis as cofactors in financial analysis. The example case used by the article was the prediction of corporate bankruptcy. Ratios traditionally measure the most important factors such as liquidity, solvency and profitability, as well as other measures of solvency. Different studies have found various ratios to be the most efficient indicators of solvency. Studies of ratio analysis began in the 1930’s, with several studies of the concluding that firms with the potential to file bankruptcy all exhibited different ratios than those companies that were financially sound. Among the study’s findings were that the deciding factor of the predictor of bankruptcy should not be only a few ratios, as the measure of a company’s financial solvency may differ as the firm’s situations differ. The important question is to which ratios are to be used and of those ratios chosen, which ratios are given priority weight. After discussions, a multiple discriminant analysis (MDA), a statistical technique, was chosen. MDA was used primarily to classify and make prediction in problems where the dependent variable was in qualitative form, e.g. bankrupt or non-bankrupt. The primary advantage of MDA was its ability to sequentially examine individual ch... ...el such as: purpose of the loan, maturity of the security pledged, the history of the client with the company and the unique characteristics that the bank’s customers might have. It was the conclusion of the author that financial ratios when combined with statistical analysis still remain a valuable tool. The theoretical conclusion was that ratios used within a multivariate framework take on a more influential role than when used in isolation. The discriminate model was very accurate in the initial sample of 66 firms, correctly predicting 94 percent of the original bankrupt firms. The potential suggested used of the model included: business credit evaluation, investment guidelines and internal control procedures. The MDA model also showed potential to ease some problems in the selection of securities of a portfolio but further investigation was recommended.