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Failing Company Discriminant Analysis

Author(s): Marc Blum

Source: Journal of Accounting Research, Vol. 12, No. 1 (Spring, 1974), pp. 1-25
Published by: Wiley on behalf of Accounting Research Center, Booth School of Business,
University of Chicago
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Failing Company Discriminant Analysis


1. Introduction


Mergers of competitors often violate antitrust laws. One

sible defenses to a merger prosecution is the Failing Company Doctrine.
This defense can be invoked when one of two merging companies is failing
and the failing company receives no offer to merge from a company with
which a merger would have been legal.
The Failing Company Model was constructed to aid in assessing the
probability of business failure, where failure is defined in accordance with
the meaning courts have imputed to it in the context of this antitrust
defense. Predictive accuracy of the Failing Company Model was evaluated
by discriminant analysis.
This article reports the results of the discriminant analysis. Detailed
discussion of the Failing Company Model and a proposed guide for de-
cisions under the Failing Company Doctrine can be found elsewhere.'


The Failing Company Doctrine was originally formulated by the Supreme

Court in International v. F.T.C.2 The rationale of the Doctrine is that the
likely harm to communities, employees, creditors, and owners associated

* 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).

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with a failing business that might be forced into a liquidation proceeding,

outweighs harm to competition caused by allowing a failing and presum-
ably weak but still intact firm to merge with a competitor.
Largely because of vagaries in the original International Shoe decision,
the appropriate circumstances for invocation of the Failing Company
Doctrine have remained murky to this day. Indeed, the Doctrine was
largely overlooked from 1930 until 1950 and has recently become quite
important only because in 1950, Congress expressly approved it during
hearings on the Celler-Kefauver amendments to the Clayton Act.
Recent use has brought to light two uncertainties in applying the Doc-
trine: (1) the point at which a company is considered failing, and (2) the
manner of ascertaining absence of good-faith purchasers for the failing
company. Legal criteria vaguely define "failing" as a "grave probability
of failure." The Failing Company Model addresses this uncertainty by
clarifying one important step in the assessment of that probability: an
empirical analysis of the financial and market data usually present in
Failing Company cases.
The determination of the absence of alternate good-faith purchasers
was focused upon in the latest Supreme Court decision concerning the
Failing Company Doctrine.3 There, the Court clarified that an antitrust
defendant carries the burden of proof on the issue of absence of alternative
good-faith purchasers.


The Failing Company Model was developed to predict failure as defined

in International Shoe. It differs from models previously discussed in the
literature in that most of the variables incorporate change over time, such
as an investor's profit from selling a security six years after purchase; and
it includes variability of accounting data, for example, the standard devi-
ation of net income.
Discriminant analysis was used to test the hypothesis that the Failing
Company Model can distinguish between failing and nonfailing firms.
The analysis was applied to a paired sample of 115 failed and 115 nonfailed
The hypothesis was substantiated. The model distinguished failing from
nonfailing firms with an accuracy of approximately 94 percent, when failure
occurred within one year from the date of prediction, 80 percent for failure
two years into the future, and 70 percent for failure three, four, and five
years distant. There are two reasons for considering the Failing Company
Model reliable-the choice of each of its variables is justified on the basis
of financial theory, and the aforementioned results are the product of a
rigorous validation procedure.

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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2. Research Design


The operational definition of failure is based on the criteria of Inter-

national Shoe, that is, events signifying an inability to pay debts as they
come due, entrance into a bankruptcy proceeding, or an explicit agreement
with creditors to reduce debts.4 Of the failed firms studied, 90 percent filed
petitions under the federal Bankruptcy Act. Private arrangements com-
prise the other 10 percent; state liquidations were excluded for lack of data.
Selection of variables for the Failing Company Model is based on a
theory of the various ways impending failure might be symptomized by
accounting data. In the absence of such a conceptual foundation, there is
little reason to expect a sustainable correlation between independent vari-
ables and the event to be predicted. A theory of symptoms of failure focuses
on how the behavior of fundamental economic variables would be expected
to be portrayed in financial statements: "The products of an accounting
system are always surrogates; they are useful only because they represent
principals, i.e., the economic events of an entity. This point can never be
overemphasized." I So viewed, a theory of symptoms highlights the in-
herent limitations of accounting data as expressed in financial statements-
that the multidimensioned complexity of the economic world must be re-
duced to scalars.6 These, however, could be viewed as describing factors
in the real world by means of certain unifying denominators: liquidity,
profitability, and variability.


To provide a general framework for variable selection, let us describe

the business firm as a reservoir of financial resources and describe its prob-
ability of failure in terms of expected flows of those resources.7 Other things

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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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
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).


The Failing Company Model, summarized in table 1, is constructed with

reference to the three common denominators underlying the cash-flow
framework: liquidity, profitability, and variability. The "quick flow" ratio
relates reservoir size and resource inflow to resource outflow. Net quick
assets/inventory indicates the relationship of both current liabilities (short-
term resource claims) and inventory (relatively illiquid component of the
reservoir) to the highly liquid quick assets (cash and equivalents, plus
accounts and notes receivable).
Cash flow/total liabilities relates resource inflow to total claims; both of
the net worth measures relate reservoir size to total claims. The profit-
ability measure, rate of return to common stockholders, reflects all of the
elements of the cash-flow framework. The last six variables indicate vari-
ability and trend of resource inflow (net income) and of the short-term
liquidity indicator, net quick assets/inventory. Industry location could
not be introduced explicitly because industry was one of the pairing cri-
teria in the paired-sample design.

3. Statistical Methodology


The accuracy of the Failing Company Model in distinguishing failing

from nonfailing firms is tested by using discriminant analysis for computing
an index and a cutoff point on the index." The index is derived from the
8 Discriminant analysis was developed by R. A. Fisher, "The Use of Multiple
Measurements in Taxonomic Problems," Annals of Eugenics 7 (1936): 184-85. A linear

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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
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.


1. Data Collection. Data drawn from balance sheets, income statements,

and stock market prices for a consecutive period of at least three years
were gathered for 115 companies which failed during the years 1954-68.9
discriminant function for two mutually exclusive groups produces discriminant
weights exactly proportional to those of multiple regression with a dummy dependent
variable. R. A. Fisher, "The Statistical Utilization of Multiple Measurements,"
Annals of Eugenics 8 (1938): 376-77. The assumptions underlying multiple discrim-
inant analysis are that each of the xi variables has a multivariate normal distribution
for all Groups; the xi variables are assumed to have different means but common
variance-covariance matrixes for all Groups. Ronald E. Frank, William F. Massy,
and Donald G. Morrison, "Bias in Multiple Discriminant Analysis," Journal of
Marketing Research 2 (August 1965): 251.
9 Principally from Standard and Poor's Corporation Records and Moody's Indus-
trial Manual, supplemented by annual reports of the companies, SEC files, the Na-

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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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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-
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.


The population of each of the twenty-one ranges was split in half. A

discriminant function was computed from the data of one half and tested
on the other, "fresh" half.'3 The secondary or "validation" sample pro-
vides a means for correcting for sampling error and for determining whethe
the statistic is more accurate in classifying the sample from which the
statistic itself is derived than in classifying an untested, random sample.
Statistical significance of group differences for each variable analyzed
by the twenty-one discriminant functions can be tested by an "F" statistic,
12 Data further in the past are not needed for predictions at the fifth and sixth
years before failure, the earliest points at which failed firms have been distinguished
from nonf ailed firms by other recent studies of business failure.
13 The program used was Duhammel, Massy, and Morrison's adaptation of the
Biomedical package program, BMD05M; developed at Stanford University in 1964,
it facilitates splitting of the samples; BMDO5M does not. See W. J. Dixon, ed., BMD:
Biomedical Computer Programs (Berkeley and Los Angeles: University of California
Press, 1968).

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which is a transformation of the Mahalanobis measure of distance, "D2." 14

The test is analogous to the test for differences between means of two sam-
ples, for instance, by Student's "t" test.
Statistical significance means only that the results at a specified signifi-
cance level would not be obtained by chance alone. It does not indicate
what the most important explanations of a relationship might be. Accuracy
of classification is the important factor in discriminant analysis.'5 Accuracy
can be considered in two dimensions: Type I, the accuracy of correctly
classifying the failed firms, and Type II, the accuracy of classifying non-
failed firms. An error of Type I would be predicting a failed firm not to
fail; a Type II error would be predicting a nonfailed firm to fail.
The two types of error usually do not produce equal penalty costs."6 For
example, creditors might be more concerned to avoid Type I because the
magnitude of loss in capital may exceed expected return from interest
payments. The cost of Type II error is the opportunity cost of not lending
to a debtor who would have been a good risk. In the antitrust decision, a
Type II error might be more costly than Type I. Allowing nonfailed com-
panies to complete mergers because of their mistaken description as failing
firms may do more injury to the interests of the public than sending gen-
uinely failing firms to their liquidation after bankruptcy proceedings.'7

4. Results of the Analysis


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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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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3. Relative Importance of the Variables. There is no definitive way to

assess the relative importance of the variables. Relative importance is
usually assessed by comparing standardized discriminant function coeffici-
ents. However, discriminant function coefficients are unstable when the
variables composing the model are highly correlated. If two variables com-
posing a multivariate model are collinear, the information each adds to
the model is similar, and their coefficients are assigned arbitrarily. Thus,
the relative weights of the variables do not necessarily signify their relative
Multicollinearity, usually found in financial data, was not as high as
might be expected. Table 9 shows the correlation coefficients for each pair
of the twelve variables for the range 2-6.20 Ranking of variables by relative
size of standardized discriminant-function coefficients is thus not definitive.
Nevertheless patterns found by comparing the relative ranking of variables
in table 10 may yield an approximation of relative importance. For in-
stance, variable 3, cash flow/total debt (Beaver's best performing ratio)
was always rated among the three most important except for four of the
five ranges beginning two years before failure. For this time period vari-
ables 5 and 11 (net quick assets/inventory and "Trend Breaks" of income)
were consistently ranked as most important. Variable 5 also received con-
sistently high rankings for the six ranges beginning one year before failure,
but it was consistently unimportant for ranges beginning three or more
years before failure.2' However, the other measure of short-term liquidity,
variable 2, the quick flow ratio, generally held to a relatively important
ranking. Variable 6 (Book Value of Net Worth/Total Debt) neatly il-
lustrates both the arbitrariness of these rankings when data are collinear
and the unstable pattern of the multicollinearity itself. The performance
of variable 6, not theorized to be of great value because of the questionable
nature of book value, was mediocre for all ranges except those beginning
three years before failure, where it ranked consistently first (one tie). With
regard to table 9, no clue is provided by the 0.06 correlation between
variables 3 and 6 for the range 2-6. However, at the third year before
failure, for example, variables 3 and 6 were quite dramatically correlated-
correlation for range 3-7 was 0.57.
4. Moving Discrirninant Functions. Another hypothesis tested was that
the predictive accuracy of the Failing Company Model would be improved
by incorporating an updating procedure. This hypothesis was not verified,
although it may well be important to build an updating procedure into the

20 What is more surprising is the apparently unstable pattern of the multicollin-

earity itself. As an example, the four ranges with a five-year interval, ranges 1-5,
2-6, 3-7, and 4-8, had correlation coefficients equal to or greater than an absolute
value of 0.30 for ten, eighteen, twelve, and nine pairs of variables, respectively. Only
two of these pairs occurred in all four ranges.
21 This finding reinforces the reasonableness of the arbitrary decision to omit
variables 8, 10, and 12 for ranges beginning three or more years prior to failure.

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Failing Company Model to allow for long-term changes in the economy

that might influence the character of business failures.


1. A Model without Financial Ratios. Since discriminant analysis assigns

weights, it might assign weights to absolute accounting data which result
in more accurate discrimination than those implicitly assigned by financial
analysts using particular ratios. An experiment was conducted to test the
predictive accuracy of a nonratio model. Five of the nine ratios used for
the years prior to the two before failure in the Failing Company Model
(table 1) were broken down into their component numerators and denomi-
nators. The total of eight different numerators and denominators were
used as eight independent variables in conjunction with the four nonratio
variables of the table 1 model to form a nonratio version of the Failing
Company Model.
Hypothesizing that discrirninant analysis with this nonratio model Will
produce accuracy at least equal to that of the Failing Company Model is a
test of the rebuttal to the traditional argument for financial ratios. As
shown in table 11, the nonratio model, while not as accurate as the Failing
Company Model in the first year before failure, is consistently more ac-
curate thereafter (for ranges with five-year intervals).
The nonratio model is not necessarily an accurate discriminator between
failing and. nonfailing firms. Its discrimination might be between large
and small firms because of the imperfection of the paired sample design
shown in table 3; nevertheless, this explanation would not account for the
relatively poor performance of the nonratio model at the year before
failure. Further experimentation, with the most precise of the 115 pairin
of companies tested by the Failing Company Model, is a matter for future
2. Anticipation of Failure by the Market. It is often supposed that prices
set by the stock market allow for, or discount, future events. While the
market rate of return and fair market value of net worth were consistently
higher for nonfailed than failed companies (see table 12), thus showing
some discrimination by the market, research in conjunction with the
Failing Company Model has indicated the stock market's inability to
anticipate the timing of failure.22 The indication is based on a new measur
the extent to which firms successfully "go to the market" by offering com
mon stock to the public or by issuing common stock to finance mergers.
"Going to the market" is measured by the fair market value of the shares
offered to the public or issued in mergers during a range of years, divided
by the sum of the fair market value of net worth of the company at the
end of each of the years in the range. If a period of four years is being con-
sidered, during which the firm issued $100,000 of common stock in a merger

22 The market does differentiate between failing and nonfailing companies; see
variables 1 and 10 in table 16.

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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

23 Edward I. Altman, "Financial Ratios, Discriminant Analysis and the Prediction

of Corporate Bankruptcy," Journal of Finance 23 (September 1968): 594. One reason
to expect that a multivariate model will be more accurate than a univariate model is
explained in W. W. Cooley and P. R. Lohnes, Multivariate Procedures for the Behav-
ioral Sciences (New York: John Wiley & Sons, 1962), p. 121.
24 Retained earnings/total assets is an imperfect surrogate for two other variables
that could be measured directly: age of the firm and its past earnings record. Re-
tained earnings accurately reflects neither. That the author considered this variable
a "new" find (Edward I. Altman, "Corporate Bankruptcy Prediction and its Impli-
cations for Commercial Loan Evaluation," The Journal of Commercial Bank Lending
[1970]:12) is not surprising in view of his inability to distinguish retained earnings
from net worth (Edward I. Altman, "Reply [to Johnson]," Journal of Finance 25
25 A validation sample was composed of a nonstratified selection of firms which
had at least one year of negative earnings during the period of 1958-61. During this
period a severe recession occurred, thus firms with one or two years of poor earnings
may not have experienced any fundamental change in their business situations. If
many of the firms selected were large, their probability of failure, despite negative
earnings, was near zero. During the period 1954-68 only ten failing firms experienced
sales of more than $20,000,000 at the fourth year before failure. No failed firms had
sales in excess of $100,000,000.

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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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be more accurate than a univariate approach.28 However, from the view-

point of the Antitrust Division, the Failing Company Model would still be
preferable to a single ratio not only because its Type II error the year be-
fore failure is as low as could be practically expected (in contrast, most of
Beaver's errors are Type II), but also because it would be less susceptible
to manipulation. Table 15 shows the Type I and Type II errors of the
univariate approach as applied to the primary and validation samples for
the twelve middle ranges.

5. Conclusions and Suggestions for Future Research

Predictive accuracy of the Failing Company Model is 93-95 percent at

the first year before failure, 80 percent at the second year, and 70 percent
at the third, fourth and fifth years before failure. At the first year before
failure, predictions of failed firms not to fail (Type II error) are rarer than
predictions of nonfailed companies to fail (Type I error).
Relative importance of the variables composing the Failing Company
Model could not be assessed definitively. Nevertheless, the cash flow/total
debt ratio, found to be the best predictor by Beaver's research, received
generally high rankings. Multicolinearity was found, but not in as high a
degree as expected; its unstable pattern at different years before failure
was even more surprising.
A regularly updated version of the Failing Company Model, based on
moving discriminant functions, was not found to improve predictive ac-
curacy. A novel measure, "Going to the market," indicated that the mar-
ket does not reliably anticipate the timing of failure.
In comparison with other studies of business failure, the Failing Com-
pany Model was demonstrated to be more reliable than a reported multi-
variate model. However, its accuracy was only approximately that of the
leading univariate study published to date. This conclusion simply rein-
forces the need for further research. At this point, there appear to be at
least four fruitful avenues for further exploration:
1. Use of nonratio variables with pairings precisely calibrated as to size;
age, a difficult concept to define, could also be introduced as a variable.
2. Use of ratios different from those of traditional analysis. For example,
if interaction between two traditional ratios is expected to be signifi-
cant, the product of the two would produce a new variable, which
might discriminate better than either of its two multiplicands.
3. Construction of a decision-tree into the experimental design. The role

28 Multivariate experiments by Beaver, "Financial Ratios as Predictors of Fail-

ure," p. 100, have not improved upon univariate accuracy. On the other hand, a recent
study of the prediction of small business failures, using "stepwise" discriminant
analysis concluded that a multivariate is better than a univariate approach. Robert
0. Edmister, "Financial Ratios as Discriminant Predictors of Small Business Fail-
ure" (Ph.D. diss., Ohio State University, 1970).

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of ratios as guides to further analysis could be simulated by "splitting"

the entire sample using criteria such as delay in publishing financial
statements or presence of preferred stock. Consider the latter. First,
companies could be split by the criterion of presence of preferred stock.
Companies with preferred stock are then split into those which have
and those which have not omitted a dividend on preferred stock during
the most recent eight years. A model like the Failing Company Model
could then be introduced to analyze the three subsets defined by the
final splits.
4. Retention of the experimental design of the Failing Company Model,
but working within its framework introduce improvements in the
seven variables that appear to be suboptimal. These variables (3, 4, 5,
6, 8, 10, and 12) include inventory and total liabilities, whose means
are shown in table 16 to be seriously counter to expectations.
Inventory declined rapidly for failing companies, which shows that, in
general, firms do not seem to fail for reasons of excess accumulation of in-
ventory, at least as shown by annual financial reports.29 Total liabilities of
nonfailed firms increased more steadily than those of failed firms, indicat-
ing that debt was a usual way for nonfailing firms to finance growth.30

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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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.

SIC-Compustat Industry Codes-Digits for Which the 116 Pairings Are Identical

4 digits 3 digits 2 digits 1 digit

Number of 46 61 100 112


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Size and Growth Comparisons for Paired Samples of Failed and Nonfailed Firms

Average ~~~~000,000)
Number of firms Average - Current
ases Fxdassets assets

62 1st yr. before Failed $14.98 $8.24 $3.33 $4.91

62 failure Nonfailed 20.92 13.02 4.48 8.54
109 4th yr. before Failed $9.53 $5.97 $2.18 $3.79
109 failure Nonfailed 13.17 8.52 3.23 5.29
Avg. increase Failed 57% 38% 53% 30%
Yr. 4 to Yr. 1 Nonfailed 59% 53% 39% 61%


Populations of the Twenty-one Ranges

108 108 108 106 100 52 8

128 128 126 120 56 7
166 164 158 78 6 Years Before
182 174 86 5 Failure;
210 112 4 Years Ending
3 the Range
- 2

6 5 4 3 2 1 0 Failure
Years Before Failure;
Years Beginning the Range


Accuracy of the Validation and (Primary) Samples for t

Interval of years
composing the More recent year before failure

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

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Errors of Type I and Type 11-Failing Company Model

Type II error Type I error

Nonfailed Total Percentage Failed Total Percentage

companies companies of Type 1I compan
predicted predicted error predicted predicted o ype I
to fail to fail err not to fail not to fail error

1-3 ....... 3 29 .10 5 33 .15

1-4 ....... 2 29 .07 1 27 .04
1-5 ........ 0 19 .00 3 25 .12
1-6 0 ....... 18 .00 2 22 .09
1-7 8 ....... 20 .40 2 8 .25
1-8 ........ 6 17 .35 2 9 .22

2-4 ........ 15 61 .25 7 45 .16

2-5 ........ 12 50 .24 6 38 .16
2-6 10 ....... 44 .23 6 36 .17
2-7 ........ 10 37 .27 3 23 .13
2-8 6 ....... 34 .18 7 26 .27

3-5 ........ 17 54 .31 9 38 .24

3-6 ...... 14 44 .32 11 38 .29
3-7 ........ 12 36 .33 8 28 .29
3-8 11 ....... 33 .33 5 21 .24

4-6 ........ 14 48 .29 8 36 .22

4-7 . ... 10 39 .26 3 25 .12
4-8 9....... 9 29 .31 7 25 .28

5-7 8 27 .30 13 37 .35

5-8 7 24 .29 10 30 .33

6-8 8 20 .40 15 34 .44


Recalculation of Expected Type II Error at the First Year Before Failure

Validation sample Primary sample

- - ~~~~~~~~~Total
1-4 1-5 1-6 1-4 1-5 1-6

Errors of Type II (predic- 2 0 0 2 1 2 7

tions of nonfailed com-
panies to fail)

Total predictions of failure 29 19 18 28 21 20 135

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Ranking of the Variables by Absolute Size of Standardize

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

Accuracy of the Nonratio Model on Ranges 1-E, 2-6


1-5 2-6 3-7 4-8

Validation sample accuracy ..89 .80 .77 .80

Primary sample accuracy .(.90) (.87) (.82) (.91)

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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

Interval of Year before failure

years com-
posing the
range 1 2 3 4 5

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

* The figures in parentheses represent Beaver's analysis applied twice to each

range. A cutoff point for the primary sample was tested on the validation sample;
then a new cutoff point was computed for the (first) validation sample and tested
on the (first) primary sample. The figures not in parentheses are the validation
sample results, comparable in data base to those of the Failing Company Model re-
ported here and in table 5.


A Measure of the Extent to Which Firms "Go to Market," Using the Primary Sample
for Each Range

1-5 2-6 3-7 4-s

Failed ............... .0409 .0130 .0379 .0289

Nonf ailed ........ .0378 .0247 .0284 .0216
Failed ............... 21 39 31 27
Nonf ailed .......... . 21 39 31 27


Accuracy of Altman's Model

Year before failure Accuracy

1 95%
2 72%
3 48%
4 29%
5 36%

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Errors of Type I and Type Il-Beaver's Cash Flow/Total Debt Ratio Applied to Failing
Company Model Data

Type II error Type I error

Nonfailed Total Percentag Failed Total Percentages

companies companies of Type II companies companies of Type I
predicted predicted error predicted predicted error
to fail to fail error not to fail not to fail error

1-4 . . 3 (5)* 31 (57)* .10 (.09)* 2 (4)* 29 (55)* .07 (.07)*

1-5... 1 (3) 23 (45) .04 (.07) 0 (1) 21 (41) .00 (.02)
1-6... 1 (3) 20 (41) .05 (.07) 0 (1) 18 (37) .00 (.03)

2-5... 10 (13) 49 (89) .20 (.15) 6 (12) 41 (87) .15 (.14)

2-6... 9 (12) 45 (83) .20 (.14) 4 (8) 35 (75) .11 (.11)
2-7... 8 (9) 34 (64) .24 (.14) 3 (5) 24 (56) .13 (.09)

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)

4-7... 11 (15) 39 (66) .28 (.23) 4 (13) 25 (62) .16 (.21)

4-8... 8 (13) 31 (61) .26 (.21) 4 (6) 23 (47) .17 (.13)

5-8... 10 (17) 32 (63) .31 (.27) 5 (8) 22 (45) .23 (.18)

* The figures in parentheses represent Beaver's analysis applied twic

primary sample was tested on the validation sample; then a new cut
validation sample and tested on the (first) primary sample. The fig
sample results, comparable in data base to those of the Failing Com

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Average Increases in Total Liabilities

Average annual increase to the Average annual increase to the 2d

1st year before failure year before failure

FROM: Failed Nonfailed Failed Nonfailed

the 2d year 27% 40%

the 3d year 18% 32% 7% 18%
the 4th year 10% 41% 1% 30%

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