A Five-State Financial Distress Prediction Model

The model presented here extends previous corporate failure prediction models (e.g., Beaver 1966, Altman 1968, Altman, Haldeman, and Narayanan 1977, Ohlson 1980, Zavgren 1985, etc.) in two ways: (1) instead of the conventional failing/nonfailing dichotomy, five financial states are used to approximate the continuum of corporate financial health; and (2) instead of classifying a firm into a certain financial state, the new model will estimate the probabilities that a firm will enter each of the five financial states. The ranked probability scoring rule is then used to evaluate the quality of such probabilistic predictions. The first extension enables the prediction of prefailure distress in addition to ultimate failure. The second extension conforms with more recent advances in prediction methodologies (see, e.g., Epstein 1969 and Murphy and Winkler 1970). Together, the two extensions provide a better approximation to the continuum of alternative financial judgment and actions in reality. Sections 2 and 3 explain the structure of the model and the data; section 4 explains the statistical methodology (multivariate logit analysis) and presents the constructed models. These models are evaluated in section 5.