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Research
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Failing Company Discriminant Analysis
MARC BLUM*
1. Introduction
LEGAL BACKGROUND
* Associated with the law firm of Gordon, Feinblatt, Rothman, Hoffberger and
Hollander in Baltimore.
1 This is one of a pair of articles based on Marc Blum, "The Failing Company
Doctrine" (Ph.D. diss., Columbia University, 1969). Focus on the condition "fail-
ing" as a subject for research was suggested in March 1967 by Edwin M. Zimmerm
then First Assistant to the Assistant Attorney General, Antitrust Division.
International Shoe v. F.T.C., 280 U.S. 291 (1930).
1
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2 JOURNAL OF ACCOUNTING RESEARCH, SPRING, 1974
8 Citizen Publishing Co. v. U.S., 394 U.S. 131 (1969) and United States v. Greater
Buffalo Press, Inc., 402 U.S. 549 (1971).
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FAILING COMPANY DISCRIMINANT ANALYSIS 3
2. Research Design
A THEORY OF SYMPTOMS
A CASH-FLOW FRAMEWORK
4By contrast, forty years after International Shoe, Citizen Publishing hinted
that mere entrance to such proceedings may not suffice. If definitions of failure are
placed on a continuum-ranging, for example, from a declining share of sales in major
markets, through omission of preferred dividends, to total dismantlement during
liquidation proceedings-bankruptcy is not the most extreme point because the
possibility of restoring the firm is not precluded. The impact of foreseeable changes
in the legal definition of failure would be a shift in weights assigned to the Failing
Company Model variables, not a change in the theoretical foundation.
5 Yuji Ijiri, The Foundations of Accounting Measurement (Englewood Cliffs, N.J.:
Prentice-Hall, 1967), p. 6.
6 K. E. Boulding, "Economics and Accounting: The Uncongenial Twins," in
Studies in Accounting Theory, ed. W. T. Baxter and Sidney Davidson (Homewood,
Ill.: Richard D. Irwin, Inc., 1962), p. 53. In the same edited collection see also Sidney
S. Alexander, "Income Measurement in a Dynamic Economy," pp. 126-200. IEiri,
pp. 4-6, 117-18, 121-31.
7William H. Beaver, "Financial Ratios as Predictors of Failure," Empirical Re-
search in Accounting: Selected Studies 1966, supplement to Journal of Accounting
Research 4 (1966): 80.
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4 MARC BLUM
being equal, one would expect that probability of failure is more likely:
1. the smaller the reservoir (a larger reservoir would be a better buffer
against uncertainties),
2. the smaller the inflow of resources from operations in both the short-
and long-run,
3. the larger the claims on the resources by creditors,
4. the greater the outflow of resources required by the operation of the
business,
5. the more highly variable are earnings and claims against resources,
represented both by outflows to maintain current operations and by
obligations to creditors (the less variable are inflows and outflows, the
more likely that future events can be predicted), or
6. the more "failure-prone" the industry locations of a firm's business
activities are expected to be (certain industries at specified times-
such as automobile manufacturing in the early twentieth century or
prefabricated home construction in the early 1960s-are characterized
by a higher frequency of failures than other industries-such as auto-
mobile or steel manufacturing in the 1960s).
3. Statistical Methodology
DISCRIMINANT ANALYSIS
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FAILING COMPANY DISCRIMINANT ANALYSIS 5
financial model by computing the values of each of its variables for each
company studied. When the variables for one company are standardized
and added together, their sum is that company's index score. A critical
score exists which results in a minimum of misclassification. If all com-
panies with index scores above the critical score are predicted to succeed
and all companies with scores below are predicted to fail, erroneous pre-
dictions will be minimized.
When a firm with an unknown group identity (failed-nonfailed) is classi-
fied by a discriminant function as similar to firms which failed in the next
year, the firm's classification will be treated as a prediction that the firm
will fail one year from the date of prediction. When the discriminant func-
tion is drawn from data four years before failure, its classification will be a
prediction of failure or nonfailure in the fourth year following the predic-
tion, not during the entire time period of the next four years.
For an algebraic interpretation of discriminant analysis consider group
membership to be determined by a line (z crit) best separating two mu-
tually exclusive groups. Let:
xji = the ith individual's value of jth independent variable.
bj = the discriminant coefficient for the jth variable.
zi = the ith individual's discriminant score.
Zcrit = the critical value for the discriminant score.
2<k< o
When each individual's discriminant score zi is a linear function of the
independent variables: zi=bo + b1 x1i + b2 X2i + ' * * + bk Xki-
The classification procedure is: If zi > Zci, classify individual i as be-
longing to Group I. If zi < Zcrit classify individual i as belonging to Group
II.
The larger the coefficient (bj) of the variable (xji), the more important
the variable is in discriminating between the two groups. Coefficient bo
affects the absolute level of Zcrit, not the relative influence of each of the
xj variables.
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6 MARC BLUM
This is the entire population of industrial firms which failed from 1954 to
1968 for which data were available and which had a minimum of
$1,000,000 in liabilities at date of failure. It was assumed that smaller firms
would not usually be of interest to the particular antitrust policy studied.
The 115 failed firms were paired with 115 nonfailed firms'0 to eliminate
the spuriously accurate predictions that could have resulted from a purely
random selection of nonfailed firms.
2. Pairing Criteria. In order to match failing companies with similar
nonfailing companies, sampling was based on four criteria, utilized in the
following order-industry, sales, employees, and fiscal year. Similarity
refers to probability of failure; the criteria were selected basically to ex-
clude companies which because of industry or size were extremely unlikely
to fail. The process of pairing might be viewed as ensuring that two ex-
tremely dissimilar companies were not matched."1
Industry was selected as the most important criterion, and it proved
difficult to define. Poor's Register provided four-digit Standard Industrial
Classification (SIC) numbers from 1961 onward. Companies failing in
prior years were assigned SIC numbers on the basis of judgment, as were
companies with more than one SIC, since SICs are assigned for every
business activity.
Size, measured by sales volume in the fourth year prior to failure, was
the next most important criterion. The fourth year was chosen to avoid
the dramatic changes-both declines and increases-many companies
experience just prior to failing. In rare cases where the industry criterion
precluded a reasonable pairing by size, the industry criterion was rejected.
The third criterion, number of employees, was used as an indicator of
tional Stock Summary, and the Financial and Commercial Chronicle. One hundred
firms were listed as large business failures by Dun & Bradstreet; the other fifteen
were reported by William Beaver.
10 The nonf ailed firms were chosen by a stratified, random sampling from the Janu-
ary 1969 index to Compustat, Standard and Poor's computerized file of companies
listed on major stock exchanges and over-the-counter. This is imperfect but approxi-
mates a random sampling of all nonf ailed firms eligible for pairing. There is no bias
other than data availability. Moreover, Compustat's 1,800 companies are about
60 percent of the total population of eligible nonf ailed firms, as estimated by the
number of domestic firms with text descriptions in 1968 Moody's Industrial Manual
(3115). An empirical indication that there was no sampling bias in favor of extremely
successful companies is that 6 of the 115 nonfailed firms would have been defined as
failed in Beaver's dissertation because preferred dividends were omitted. Also, sales
for both failed and nonf ailed firms experienced similar growth (55-60 percent), from
the fourth to the first year before failure (see table 3).
11 The relation of accuracy of the Failing Company Model to the pairing procedure
is a subject for sensitivity analysis. See John C. G. Boot, Mathematical Reasoning in
Economics and Management Science (Englewood Cliffs, N.J.: Prentice-Hall, 1967),
pp. 126-36. With industry and size as pairing criteria, it is doubtful that the accuracy
of the model is sensitive to the manner in which the pairing procedure was executed
because the 115 nonfailed companies chosen are, for the most part, the 115 smallest
companies on Compustat with data available.
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FAILING COMPANY DISCRIMINANT ANALYSIS 7
both size and industry. The fourth criterion, fiscal year, was used to
break ties.
Tables 2 and 3 show the number of pairings identical according to each
of four SIC digits and the average size of the failed and nonfailed groups
by sales, total tangible assets, fixed assets, and current assets for the
fourth and first years before failure.
3. Time Periods. Where available, data were gathered for eight fiscal
years.12 The range of years "one to three before failure" is thus the most
recent time period for both failed and nonfailed firms. Since the minimum
time period selected for analysis is three years, there is a maximum of
twenty-one possible ranges of years, shown in table 4 with the population
of each range.
Other things being equal, younger firms are more likely to fail than older
firms. However, age was excluded as a variable because firms for which it
would be most useful, those with less than three years of published financial
statements and stock market quotations, were not studied because their
data did not suffice for computation of measures of variability and profit-
ability.
It would be expected that the more recent and the longer the time period
is, the higher the accuracy of index scores drawn therefrom will be, subject
to one exception, that a period can be "too long" if it includes the first
years of existence of a company. Because the first years of young companies
are often not typical of the scale and nature of operations that later lead
to failure, and because the influence of age was not researched explicitly,
time periods exceeding six years were arbitrarily deemed to include such
"first years." Thus the "middle" ranges, those with ranges of four, five,
and six year periods, presumably excluding unrepresentative early years of
young companies, were expected to be more reliable for predictive purposes.
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8 MARC BLUM
1. The Major Results. The Failing Company Model, with regard to the
"middle" ranges, predicts failed companies to fail and nonfailed companies
not to fail with an accuracy of approximately 93 to 95 percent at the first
year before failure. Predictive accuracy is approximately 80 percent at the
second year before failure and is 70 percent at the third, fourth, and fifth
years before failure. Discrimination between failed and nonfailed companies
is not found to be statistically significant at the sixth year before failure.
Table 5 compares the accuracy of the validation sample for each range
with that of the primary sample (the figures in parentheses). The rows of
table 5 represent the same interval of years; the columns contain ranges
14 Fisher, "The Statistical Utilization of Multiple Measurements," pp. 378-81.
1l Donald G. Morrison, "On the Interpretation of Discriminant Analysis," Journ
of Marketing Research 6 (May 1969): 156.
10 The ratio of the costs, if known, can be built into the discriminant funct
Morrison, p. 161.
17 However, even the Antitrust Division might be more eager to avoid Type I
error when other dimensions of antitrust policy are involved. Suppose Company A
is stagnating in an industry important to antitrust policy and requests a letter of
clearance to sell a failing subsidiary to the leading competitor for that subsidiary in
an industry much less important to antitrust policy. The Antitrust Division might be
less willing to risk A's decline in its major industry than to risk an increase in anti-
competitive features in the subsidiary's industry.
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FAILING COMPANY DISCRIMINANT ANALYSIS 9
with the same most recent year. Thus, reading across the rows shows the
hypothesized result that the "middle" ranges of four, five, and six years
usually produce higher predictive accuracy than ranges of three, seven,
and eight years; reading down the columns shows the change in predictive
accuracy which occurs when data further in the past are included. For
example, column 1 shows that accuracy in predicting failure within the
next year increases when the range is extended from three to four, five,
and six years before failure. Further extension of the range to include data
seven and eight years before failure results in greatly reduced accuracy.
The statistical significance of these results was tested in two ways. The
Mahalanobis measure D2 was transformed to x2, and the x2 statistic showed
the means to be different at the 0.01 level of significance for each of the
twenty-one ranges.
The second test of significance was x2 applied to a 2 X 2 classification
matrix for each validation sample for the twenty-one ranges to test the
statistical significance of predictive accuracy. Of the twenty-one ranges,
eighteen had significant results at the 0.01 level of significance. Ranges
1-7 and 1-8 were significant only at the 0.10 level; range 6-8 was not
statistically significant at the 0.10 level.18 Table 6 shows the standardized
discriminant coefficients for the twenty-one ranges.
2. Type I and Type 11 Error. Table 7 displays the overall accuracy of
the Failing Company Model in terms of Type I error (the probability that
a firm predicted notto fail will fail) and Type II error (the probabilitythat a
firm predicted to fail will not fail). Type II error is seen from table 6 to be
somewhat less frequent than Type I error for the first year before failure,
with reference to the ranges 1-3, 1-4, 1-5, and 1-6.19
For purposes of the Failing Company Doctrine, the most interesting
feature of the breakdown of overall accuracy into Type I and Type II
errors is the extremely low level of Type II error for the "middle" ranges
at the first year before failure, ranges 1-4, 1-5, and 1-6. In fact, the vali-
dation samples for ranges 1-5 and 1-6 reveal a total absence of Type II
error over the entire period, 1954-68, for which data were collected. A
probability of zero Type II error is not expected to continue in the future.
Therefore, Type II error at the first year before failure will be estimated
by considering the primary and validation samples for ranges 1-4, 1-5,
and 1-6 as one group. Table 8 shows estimated Type II error to be 5 per-
cent-7 of 135 predictions of failure were erroneous.
18 Two unusual features of the Failing Company Model require comment: (i) the
primary sample accuracy for ranges 1-4 and 1-6 is lower than the validation sample
accuracy (see table 8); the differences of 2 to 3 percent probably reflect chance varia-
tion; and (ii) the Failing Company Model exhibits similar accuracy for the third,
fourth, and fifth years before failure; one would have expected the model to decline
in accuracy over time.
19 As discussed above, ranges 1-7 and 1-8 are not considered reliable; all Type II
errors in ranges 1-7 and 1-8 are eliminated in ranges 1-5 or 1-6, which include every
company in the longer ranges.
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10 MARC BLUM
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FAILING COMPANY DISCRIMINANT ANALYSIS 11
FURTHER EXPERIMENTS
22 The market does differentiate between failing and nonfailing companies; see
variables 1 and 10 in table 16.
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12 MARC BLUM
that made no other capital change, the measure of the extent to which the
firm went to the market would equal ($100,000 + 0 +0 + 0), the sum of
fair value of net worth for each of the four years.
If the market anticipates failure accurately, one would expect that the
market would not invest further capital in a failing firm and that even if
the market did so invest, expecting profits justified by the perceived risk
of failure, the measure "Going to the Market" would be higher for non-
failing than failing firms. But the results in table 13 show the market
prefers to invest in failing rather than nonfailing firms.
3. Comparison of the Failing Company Model with Altman's Multivariate
Study. Altman's multivariate discriminant analysis23 of data from the year
prior to failure, for a paired sample of failed and nonfailed firms, yielded
the accuracy in classification shown in table 14. Altman reduced twenty-
two original variables to five (working capital/total assets, earnings before
interest and taxes/total assets, retained earnings/total assets,24 market
value equity/book value of total debt, and sales/total assets) by searching
through various discriminant functions to find the one that predicted best.
Apparently, Altman's model was found to predict at the year before
failure with an accuracy of 94 percent on the primary sample and 96 per-
cent on a partial validation sample, consisting only of failed companies, a
slight turnaround in line with the performance of the Failing Company
Model for ranges 1-4 and 1-6 (see tables 1 and 5). However, after the first
year before failure an even less rigorous validation procedure seems to
have been followed.25
In addition, the model produces illogical results regardless of temporal
assumptions. If the discriminant function derived from data based on the
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FAILING COMPANY DISCRIMINANT ANALYSIS 13
year before failure had been used for less recent years, an implicit assump-
tion is made that discriminant coefficients are invariant with respect to
time. Thus a firm would be predicted to fail at an unspecified time. Such
predictions become self-contradictory when the accuracy of the model
inverts, as shown in table 14. Beyond the third year, Altman's model be-
comes considerably less accurate than even a chance procedure. In the
fourth year, for example, accuracy could be increased to 71 percent by
inverting the decision-rule, which could be stated: When failure would
have been predicted, predict nonfailure, and vice versa. However, at the
time of decision one does not know whether the firm is at the fourth or, for
instance, the second year before failure. One is then left with a decision-rule
which predicts both failure and nonfailure for discriminant scores both
above and below the cutoff point.
If, on the other hand, predictions for years prior to the first before failure
had been based on functions derived from data for each of those years, so
that no assumption is made that the discriminant coefficients are invariant
with respect to time, accuracy could still be improved by inverting the
decision-rule, thus laying bare the defects of searches for financial predic-
tors that are selected without theoretical justification and without sound
validation procedures.
4. Comparison of the Failing Company Model with Beaver's Univariate
Model. Beaver analyzed thirty ratios popular in the financial literature.26
His best ratio, cash flow to total debt, was 87 percent accurate in predicting
failure for seventy-nine failed firms and nonfailure for seventy-nine non-
failed firms at the first year before failure. Predictive accuracy of this ratio
was also high for the second through fifth years before failure, ranging
from 75 to 80 percent. In a later study,27 Beaver found that market-value
variables and financial ratios tended to misclassify the same firms and that
ratios were not more reliable than market variables.
The Failing Company Model is compared with Beaver's best ratio, cash
flow to total debt, in table 12. Beaver's analysis was performed on the
primary and validation samples for the twelve middle ranges.
Table 12 shows the accuracy of the univariate approach and the Failing
Company Model to be similar. This is surprising, since the multivariate
Failing Company Model included Beaver's best ratio and was expected to
26 Beaver, "Financial Ratios as Predictors of Failure," pp. 81 and 85. As an aside,
two technical problems should be noted with Beaver's method for determining cutoff
points-there is no necessarily unique cutoff (several may be optimal), and cutoff
points lower in years further from failure than those closer to failure produce incon-
sistent predictions (e.g., for a decision rule predicting failure when a ratio is below
a cutoff point, and vice versa, suppose the cutoff points for the third and fourth
year before failure are X and Y, where X, Y > 0 and X > Y; then a company with
a ratio between X and Y would be predicted to fail in three years, but succeed in four).
27 William H. Beaver, "Market Prices, Financial Ratios, and the Prediction of
Failure," Journal of Accounting Research 6 (Autumn 1968).
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14 MARC BLUM
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FAILING COMPANY DISCRIMINANT ANALYSIS 15
29 The ratio of net quick assets/inventory, concerning four of the seven suboptimal
variables, ran doubly counter to expectations. Inventory increased for nonf ailing and
decreased for failing firms; net quick assets decreased from the fourth to the first
year before failure almost as rapidly for nonf ailing firms (-80 percent) as for failing
firms (-100 percent). This may reflect the fact that data for the majority of the 230
studied companies were from the 1960s, an era of increasingly tight money. Perhaps
credit management was more important than inventory.
30 Table 17 indicates that during the third and fourth years before failure, failing
firms already may have contracted for as much debt as could be acquired at "normal"
rates. But their financial plight became so severe in the two years prior to failure that
they obtained credit (27 percent more from the second to the first year before failure)
in any way possible.
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16 MARC BLUIM
TABLE I
The Failing Company Model
I. Liquidity:
A. Short-Run Liquidity
Flow: 1. The "quick flow" ratioa
Position: 2. Net quick assets/inventory
B. Long-Run Liquidity
Flow: 3. Cash flow/total liabilities
Position: 4. Net worth at fair market value/total liabilities"
5. Net worth at book value/total liabilities
II. Profitability: 6. Rate of return to common stockholders who invest for a mini-
mum of three years0
III. Variability: 7. Standard deviation of net income over a period
8. Trend breaks for net incomed
9. Slope for net incomee
10-12. Standard deviation, trend breaks, and slope of the ratio, net
quick assets to inventory; variables 10, 11, and 12 are only
used at the first and second year before failure.
a Cash + Notes Receivable + Market Securities + (Annual Sales + 12) . (Cost of Goods Sold-Depre-
ciation Expense + Selling and Administrative Expense + Interest) . 12.
b Fair market value was measured by the harmonic mean of the bounds to the range of stock prices duri
year. The implicit weighting system of the harmonic mean is inverse to the size of the observation (the re
:iprocal of the arithmetic average of reciprocalo)-thus speculative upsurges in market value will not be as
nfluential as in the case of the arithmetic mean.
? The market rate of return accrues to a common stockholder who bought his shares at an average price
at the beginning of a given time span (e.g., from the fifth to the first year before failure) and sold them at an
average price during the last year of the span. The rate of return is based on the stockholder's gain or loss and
cash dividends received, all adjusted for temporal location by present-value analysis. The internal rate of
return to an investor and all variables using net worth at fair market value were adjusted for capital changes.
To compare entities more nearly similar, shares issued in mergers or offered to the public were added to prior
totals of shares outstanding, adjusted for stock splits and dividends.
d A trend break is defined as any performance by a variable less favorable in one year than in the preceding
year, such as a decline in income from $10,000 to $1,000 from year three to year four before failure.
0Slope of a "trend" line fitted to the group of observations by the method of least squares.
TABLE 2
SIC-Compustat Industry Codes-Digits for Which the 116 Pairings Are Identical
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FAILING COMPANY DISCRIMINANT ANALYSIS 17
TABLE 3
Size and Growth Comparisons for Paired Samples of Failed and Nonfailed Firms
Average ~~~~000,000)
Number of firms Average - Current
ases Fxdassets assets
TABLE 4
6 5 4 3 2 1 0 Failure
Years Before Failure;
Years Beginning the Range
TABLE 5
Interval of years
composing the More recent year before failure
range
1 2 3 4 5 6
3 .87 .79 .72 .74 .67 .57
(.92) (.84) (.76) (.79) (.80) (.81)
4 .95 .80 .70 .80 .69
(.93) (.88) (.80) (.86) (.83)
5 .93 .80 .70 .70
(.95) (.90) (.82) (.83)
6 .95 .78 .70
(.92) (.95) (.87)
7 .64 .74
(.96) (1.00)
8 .69
(1.00)
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18 MARC BLUM
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FAILING COMPANY DISCRIMINANT ANALYSIS 19
TABLE 7
Errors of Type I and Type 11-Failing Company Model
TABLE 8
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20 MARC BLUM
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FAILING COMPANY DISCRIMINANT ANALYSIS 21
TABLE 10
Variables
iRange -- - -- - - -- - _i
1 2 3 4 $ 6 7 8 9 10 11 12
1-3 ..... 9 5 1 10 2 5 12 5 4 10 5 3
1-4 ..... 8 3 1 6 4 5 11 11 6 10 8 2
1-5 ..... 7 9 2 3 1 11 5 9 12 3 5 7
1-6 ..... 7 7 1 3 6 7 11 3 12 5 2 10
1-7 ..... 11 7 3 8 5 6 9 2 4 1 12 9
1-8 ..... 11 7 3 3 6 5 12 2 4 1 9 7
2-4 ..... 8 3 7 11 4 5 8 1 8 12 2 5
2-5 ..... 9 4 7 6 1 11 10 3 12 2 5 7
2-6 ..... 5 3 8 6 1 10 6 10 9 4 1 10
2-7 ..... 4 6 1 12 2 7 10 10 8 3 4 9
2-8 ..... 10 9 5 12 1 6 4 11 8 3 1 7
3-5 ..... 5 4 1 3 8 1 7 9 5
3-6 ..... 7 5 2 4 8 1 6 8 3
3-7 ..... 8 4 2 3 8 1 6 5 6
3-8 ..... 9 5 2 4 7 1 5 8 3
4-6 ..... 3 4 1 2 7 7 7 6 5
4-7 ..... 4 3 1 2 9 4 8 4 7
4-8 ..... 9 4 2 6 8 6 4 3 1
5-7 ..... 2 7 1 4 7 4 9 3 4
5-8 ..... 5 6 2 6 8 9 4 2 1
6-8 ..... 9 5 3 8 6 7 3 1 2
TABLE 11
Accuracy of the Nonratio Model on Ranges 1-E, 2-6
Range
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22 MARC BLUM
TABLE 12
Comparison of Accuracy of Validation Samples between Beaver's Best Ratio (Cash
Flow/Total Debt) and the Failing Company Model (FCM) for Data from the Twelve
"Middle" Ranges
Beaver 4 .92 (.92)* .82 (.86)* .70 (.74)* .77 (.78)* .72 (.77)*
FCM 4..... 4 .95 .80 .70 .80 .69
Beaver 5 .98 (.95) .84 (.87) .66 (.68) .78 (.82)
FCM 5..... 5 .93 .80 .70 .70
Beaver 6 6 *97 (.95) .81 (.88) .65 (.69)
FCM 6..... 6 .95 .78 .70
TABLE 13
A Measure of the Extent to Which Firms "Go to Market," Using the Primary Sample
for Each Range
Range
Firms
1-5 2-6 3-7 4-s
TABLE 14
1 95%
2 72%
3 48%
4 29%
5 36%
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FAILING COMPANY DISCRIMINANT ANALYSIS 23
TABLE 15
Errors of Type I and Type Il-Beaver's Cash Flow/Total Debt Ratio Applied to Failing
Company Model Data
3-6 ... 19 (32) 55 (103) .35 (.31) 7 (11) 31 (61) .23 (.18)
3-7 ... 17 (21) 44 (65) .39 (.32) 5 (19) 20 (61) .25 (.31)
3-8... 14 (16) 36 (52) .39 (.31) 5 (17) 18 (54) .28 (.31)
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24 MARC BLUM
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FAILING COMPANY DISCRIMINANT ANALYSIS 25
TABLE 17
Average Increases in Total Liabilities
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