FOURNAL OF FINANCE

The Fournal of FINANCE

Vou. XXII Sepreamen 1968

FINANCIAL RATIOS, DISCRIMINANT ANALYSIS AND
‘THE PREDICTION OF CORPORATE BANKRUPTCY

Epwarp I. Avtuan*

ACADEMICIANS SEEAt to be moving toward the elimination of ratio analysis as
an analytical technique in assessing the performance of the business enterprise.
Theorists downgrade arbitrary rules of thumb, such as company ratio compari
sons, widely used by practitioners. Since attacks on the relevance of ratio
analysis emanate from many esteemed members of the scholarly world, does
this mean that ratio analysis is limited to the world of “nuts and bolts”? Or,
has the significance of such an approach been unattractively garbed and there-
fore unfairly handicapped? Can we bridge the gap, rather than sever the link,
between traditional ratio “analysis” and the more rigorous statistical tech-
niques w


hich have become popular among academicians in recent years?

‘The purpose of this paper is to attempt an assessment of this issue—the
quality of ratio analysis as an analytical technique. The prediction of corporate
bankruptcy is used as an illustrative case.* Specifically, a set of financial and
economic ratios will be investigated in a bankruptcy prediction context wherein
a multiple discriminant statistical methodology is employed. The data used in
the study are limited to manufacturing corporations.

A brief review of the development of traditional ratio analysis as a technique
for investigating corporate performance is presented in section I. In section IT
the shortcomings of this approach are discussed and multiple discriminant anal-
ysis is introduced with the emphasis centering on its compatibility with ratio
analysis in a bankruptcy prediction context. The discriminant model is devel-
oped in section III, where an initial sample of sixty-six firms is utilized to
establish a function which best discriminates between companies in two mutu-
ally exclusive groups: bankrupt and non-bankrupt firms. Section TV reviews
empirical results obtained from the initial sample and several secondary sam-
ples, the latter being selected to examine the reliability of the discriminant

Assistant Profesor of Finance, New York University, The author acknowledges the helpful
suggestions and comments of Keith V. Smith, Edward F. Renshaw, Lawrence S. Ritter and the
Journal's reviewer. The research was conducted while under a Regents Fellowship at the University
of California, Los Angeles.

1, In this study the term bankruptey will, except where otherwise noted, refer to those firms
that are legally bankrupt and either placed In receivership or have been granted the right to te-
organize under the provisions of the National Bankruptcy Act.

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