Financial Ratios, Discriminant Analysis and the Prediction of Corporate BankruptcyANKRUPTCY – ARTICLE SUMMARY

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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 …show more content…
The ratios used in the evaluation were chosen based on their popularity, potential relevancy and a few ratios that were created for the study. The original 22 ratios were narrowed and the final discriminate function was determined to be the sum of the following five ratios which were multiplied by their corresponding weight: working capital/total assets (.012), retained earnings/total assets (.014), earnings before interest and taxes/total assets (.033), market value of equity/book value of total debt (.006), and sales/total assets (.999). Once the firms discriminate coefficients were determined, it was possible to place the firms into one of the two groups. The firms with the greatest potential for bankruptcy were determined to have the lowest discriminant score. The empirical results included an “accuracy-matrix.” The accuracy matrix included the predicted placement of the company based on its discriminate score versus the actual financial solvency result of the company. From this matrix it was possible to determine the hits and misses of the study. The final measure to determine that the best model to predict bankruptcy was chosen was a series of six tests which included: (1) initial sample, (2) results two years prior to bankruptcy, (3) potential bias and validation techniques, (4) secondary sample of bankrupt firms, (5)

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