Financial Statement Analysis and the Prediction of Financial Distress

Abstract Financial statement analysis has been used to assess a company’s likelihood of financial distress – the probability that it will not be able to repay its debts. Financial statement analysis was used by credit suppliers to assess the credit worthiness of its borrowers. Today, financial statement analysis is ubiquitous and involves a wide variety of ratios and a wide variety of users, including trade suppliers, banks, creditrating agencies, investors and management, among others. Financial distress refers to the inability of a company to pay its financial obligations as they mature. Empirically, academic research in accounting and finance has focused on either bond default or bankruptcy. The basic issue is whether the probability of distress varies in a significant manner conditional upon the magnitude of the financial statement ratios. This monograph discusses the evolution of three main streams within the financial distress prediction literature: The set of dependent and explanatory variables used, the statistical methods of estimation, and the modeling of financial distress. For over 100 years, financial statement analysis has been used to assess a company’s likelihood of financial distress – the probability that it will not be able to repay its debts. Financial statement analysis was used by credit suppliers to assess the credit worthiness of its borrowers. In many cases, there was little alternative, reliable information, other than the general reputation of the borrower. A major force for the audit of financial statements arose from the demand to help ensure more reliable financial statements. For example, major users were trade suppliers allowing companies to purchase inventory on credit until the goods could be resold. For these users, there was an emphasis on shortterm ability to repay, given the focus on ability to repay over the period of inventory turnover (typically a matter of 30-60 days). In this context, the current ratio (the ratio of current assets to current liabilities) was one of the first and most prominent ratios used.1 Today, financial statement analysis is ubiquitous and involves a wide variety of ratios and a wide variety of users, including trade suppliers, banks, credit-rating agencies, investors and management, among others. Moreover, financial statements are only one among many sources of information about a company. Financial distress refers to the inability of a company to pay its financial obligations as they mature. Empirically, academic research in accounting and finance has focused on either bond default or bankruptcy. The basic issue is whether the probability of distress varies in a significant manner conditional upon the magnitude of the financial statement ratios. This monograph discusses the evolution of three main streams within the financial distress prediction literature: the set of dependent and explanatory variables used, the statistical methods of estimation, and the modeling of financial distress. The outline of the monograph is as follows: Section 1 discusses concepts of financial distress. Section 2 discusses theories regarding the use of financial ratios as predictors of financial distress. Section 3contains a brief review of the literature. Section 4 discusses the use of market price-based models of financial distress. Section 5 develops the statistical methods for empirical estimation of the probability of financial distress. Section 6 discusses the major empirical findings with respect to prediction of financial distress. Section 7 briefly summarizes some of the more relevant literature with respect to bond ratings.Section 8 presents some suggestions for future research, and Section 9 presents concluding remarks.