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Predicting corporate bankruptcy using multivariant discriminate analysis (MDA), logistic regression and operating cash flows (OCF) ratio analysis A Cash Flow-Based Approach
PREDICTING CORPORATE BANKRUPTCY USING MULTIVARIANT DISCRIMINATE ANALYSIS (MDA), LOGISTIC REGRESSION AND OPERATING CASH FLOWS (OCF) RATIO ANALYSIS: A Cash Flow-Based Approach By Christopher Scott Rodgers for Golden Gate University San Francisco, CA UMI Number 3459530 All rights reserved INFORMATION TO ALL USERS The quality of this reproduction is dependent upon the quality of the copy submitted In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted Also, if material had to be removed, a note will indicate the deletion UMT Dissertation Publishing UMI 3459530 Copyright 2011 by ProQuest LLC All rights reserved This edition of the work is protected against unauthorized copying under Title 17, United States Code ProQuest LLC 789 East Eisenhower Parkway PO Box 1346 Ann Arbor, Ml 48106-1346 Golden Gate University Doctor of Business Administration Program DISSERTATION Title: PREDICTING CORPORATE BANKRUPTCY USING MULTIVARIANT DISCRIMINATE ANALYSIS (MDA), LOGISTIC REGRESSION AND OPERATING CASH FLOWS (OCF) RATIO ANALYSIS: A Cash Flow-Based Approach Christopher Scott Rodgers Submitted in Partial Satisfaction of the requirements for the degree of Doctor of Business Administration AGENO SCHOOL OF BUSINESS GOLDEN GATE UNIVERSITY Hamid Shomali, Ph.D. iTkfeGbsfci (J&<UM Vi Miro Costa, Ph.D David Hua, Ph D DATE: May 2011 1 PREDICTING CORPORATE BANKRUPTCY USING MULTIVARIANT DISCRIMINATE ANALYSIS (MDA), LOGISTIC REGRESSION AND OPERATING CASH FLOWS (OCF) RATIO ANALYSIS: A Cash Flow-Based Approach Christopher Scott Rodgers Golden Gate University, 2011 Abstract In this paper, we will discuss current solvency evaluation methods, explore their inherent weaknesses and propose a cash flow-based alternative that may be more effective m identifying candidates that are susceptible to financial failure. We believe this research will benefit corporate business managers of both public and private firms m helping them to identify and to take constructive action to correct potentially crippling situations. We also believe it will be of value to equity and debt investors, by providing them with more timely and accurate analysis for investment decisions. Lastly, it should be of value to auditors in assessing a firm ability to continue as a Agoing concern' and issuing opinions. 1 Dedication I would like to thank my wife, Candace and my family for their patience and support during this endeavor. I would also like to thank the fine academic institutions I have served during this period for their contribution to the successful completion of this project. I would especially like to thank my committee, Dr. Hamid Shomali, Dr. Miro Costa, and Dr. David Hua for their direction, assistance and support. I would also like to thank Dr. Nabil Rageh, my program director for his understanding and consideration of the circumstances I faced while on this journey. I would also like to dedicate the substance of this work in loving memory of my father, Garland, who saw in me what I could not see in myself. Without the help of the aforementioned entities, none of this work would have been possible. 11 Table of Contents: 0 Introduction 11 Objectives of the Study 1 2 Background 0 Review of Literature 2 1 Bankruptcy An Overview 2 2 Financial Failure in the United States 2 2 1 Financial Failures (1980 to 1999) 2 2 2 Financial Crisis in the Early 2000's 2 2 3 Financial Crisis in the Late 2000's 2 2 4 Financial Failures 2010 and beyond 2 3 Traditional Financial Ratio Analysis 2 4 Ratio Analysis as a Predictor of Bankruptcy 2 5 Weaknesses of Accrual-Based Ratios 2 6 Growth Rates and Insolvency 2 7 Analyzing the Statement of Cash Flows 2 8 Capital Structure and Insolvency 2 9 Quarterly Versus Audited Financial Statements 2 10 Cash Flow-Based Ratios and Analysis 0 Methodology 3 1 The Scope of the Study 3 11 The Bankrupt Sample 3 12 The Non-Bankrupt Sample 3 2 Procedures for Analysis of the Financial Statements 3 2 1 Cash Flow-Based Ratios Used in the Study 3 2 2 Calculations and Adjustments Employed 3 3 Statistical Methods Employed 3 3 1 Using Traditional Regression Analysis 3 3 2 Refining Results Using Logistical Regression 3 3 3 Expected Contributions of the Methods Selected 3 4 Hypothesis Testing 3 4 1 Testing Hypothesis 1 3 4 2 Testing Hypothesis 2 3 4 3 Testing Hypothesis 3 4 0 Findings 4 1 Results of Hypothesis Testing 4 11 Results of Testing Hypothesis 1 4 12 Results of Testing Hypothesis 2 4 13 Results of Testing Hypothesis 3 4 2 Testing the Holdout Sample 4 2 1 Testing Using Descriptive Statistics 4 2 2 Testing Using the T-Statistic 4 3 The Z-Score Ratios and Their Justification 5 0 Conclusions and Recommendations 5 1 Conclusions Drawn from the Study 5 2 Recommended Use of Study Results 5 3 Suggestions for Future Research 5 3 1 Further Z-Score Testing of Financial Institutions 5 3 2 Testing Solvent Periods of Bankrupt Sample 5 3 3 Development of a Hybrid Score 5 3 4 Testing Market Indexes Components with Z-Score 5 3 5 Testing Our Model Against Altman's Z-Score 5 4 In Closing l_AIIIUIl3 • • • •• a a a a •• •• •• a •••• aaa • • •• a Exhibit 1 List of Bankrupt Companies Exhibit 2 List of Non-Bankrupt Companies Exhibit 3 List of Cash Flow-Based Ratios Exhibit 4 MDA Run (37 Ratio Tested, All Companies) Exhibit 5 MDA Test Results 37 Ratios-80 Companies Exhibit 6 MDA Test Results 30 Ratios-80 Companies Exhibit 7 VIF Run (Top Five Ratios) Exhibit 8 Logistic Regression Run (Top Five Ratios) Exhibit 9 Z-Scores for Bankrupts Firms (Six Quarters) Exhibit 10 Z-Scores for Non-Bankrupt Firms (Six Quarters) Exhibit 11 Original Non-Bankrupt Sample vs Original Bankrupt Sample Exhibit 12 Summary of Z-Score Fails Exhibit 13 Z-Scores for Hold Out Samples Exhibit 14 Original Bankrupt Sample vs Bankrupt Hold Out Sample Exhibit 15 Original Non-Bankrupt Sample vs Non-Bankrupt Hold Out Sample Exhibit 16 Bankrupt Hold Out Sample vs Non-Bankrupt Hold Out Sample References PREDICTING CORPORATE BANKRUPTCY USING MULTIVARIANT DISCRIMINATE ANALYSIS (MDA), LOGISTIC REGRESSION AND OPERATING CASH FLOW (OCF) RATIO ANALYSIS: A Cash Flow-Based Approach Chapter 1: Introduction 1 1 Objectives of the Study In this paper, we will discuss current solvency evaluation methods, explore their inherent weaknesses and propose a cash flow-based alternative that may be more effective in identifying candidates that are susceptible to financial failure. We believe this research will benefit corporate business managers of both public and private firms in helping them to identify and to take constructive action to correct potentially crippling situations. We also believe it will be of value to equity and debt investors, by providing them with more timely and accurate analysis for investment decisions. Lastly, it should be of value to auditors in assessing a firm's ability to continue as a 'going concern' and issuing opinions. In order to accomplish these objectives we will be evaluating financial statements using ratios derived primarily from cash flow statement data. Our initial 1 samples will include 30 of the largest corporate bankruptcies that have occurred in the last 20 years and 30 of the best performing firms based on their five-year return to stockholders. Cash flow-based ratios will be calculated for these 60 firms then statistically evaluated, first using backward-regression, and then re-evaluated using logistic regression. We intend to develop a z-score by using the coefficients determined by logistic regression then retesting both samples to evaluate how accurate and effective the model is in properly classifying the firms as either bankrupt or non-bankrupt. We will then retest the model using a holdout sample of ten bankrupt and ten non- bankrupt companies to further validate its effectiveness. We believe that the z-score developed in this study will be effective in identifying and classifying 'at risk' companies and will assist managers, creditors and evaluators as a screening tool for solvency. We further believe this tool, along with other analysis, can lead to better solvency and risk assessment decisions. 1 2 Background Twenty of the largest corporate bankruptcies in U.S. history have occurred since 1987. (bankruptcydata.com) Although some of these business failures, such as General 2 [...]... below the Altman cutoff 2.5 Weaknesses of Accrual-Based Ratios The inherit weaknesses of accrual-based ratios may be in their accumulation and reporting formats Balance sheet 22 data is static and measures only a single point in time Income statement data includes many arbitrary non -cash allocations such as depreciation and amortizations Jang, 2004) required Capital asset and equity under GAAP to be... Both are of calculated these proxies (P/E) and the dividend using may earnmgs-per-share have little or no relationship to the actual cash flow generated by current or future operational activities 20 2.4 Ratio Analysis as a Predictor of Bankruptcy In the mid-1930's, financial ratio analysis was in its infancy firms Smith and Winakor had firms substantially (1935) observed that failing weaker ratios than... assets and payables as they relate to average daily sales, cost of goods sold and credit purchases Financial leverage ratios attempt to assess a firm's borrowing capacity, ability to make interest payment and to crudely estimate financial risk (Higgins, 2001) Profitability ratios measure a firm's ability to maintain or to grow its margins at its gross, operating and net profit levels, while market ratios... most cases is accrualbased and focuses on profits calculated accepted accounting principles (GAAP) using generally rather than cash generated from operations Most liquidity ratios are derived by evaluating the relationship liabilities between current assets and current Under this analysis, all current assets are considered to be essentially as liquid as cash current ratio all current assets are included... accrual-based analysis methods, the entrance into each of these stages may be more of a result of inadequate operating cash flow rather than a lack of accrued income and profit It is not unusual for a troubled firm to have positive profit margins and still be unable to meet its current cash- flow needs Zeller and Stanko (1994) demonstrated that accrual-based analysis occasionally failed to reveal the severe... always be the responsibility of stakeholders 2 3 Traditional Financial Ratio Analysis In order to inform and protect private investors and creditors, strict publicly reporting traded standards corporations and regulators and private analysts scrutiny must from abide to government (Fraser & Ormiston 1998) Publicly traded firms are required to file quarterly (lOQs) 18 and annual (lOK's) operational and. .. multiplier ratio (Sales/Total Assets) (Total Assets/Total Equity) times its equity Our concern with 25 this formula is that it assumes cash will increase at the same rate as retained earnings 2.7 Analyzing the Statement of Cash Flows The cash sections; flow cash statement flows is provided broken by up into operating three activities, investing activities and financing activities (SFAS 95) Cash flows include... dramatically financial different distress, cash flow generally patterns Firms reorganization will generally have a negative from operations, a positive cash flow display in cash flow from investing activities and a negative cash flow from financing The positive the inflow from investing is usually due to liquidation of excess assets and negative cash flows from financing as they work to satisfy stakeholders... on Beaver's study, Altman (1968) employed a multivariant identify, rank discriminate and weight analysis financial (MDA) ratios model that strongly correlated to recent corporate failures to were His ex- ante study focused primarily on manufacturing firms and was successful in predicting bankruptcies 12 months in advance 95% of the time and two years prior to failure 72% of the time, (Gallmger and Poe,... balances are at their historical reflective of current market values and represent monies that have already been spent, (Higgins, 2001) Mills and Yamamura (1998) concluded that cash flow information may be more reliable in determining liquidity than balance sheet information that implicitly suggests that other current assets are as liquid as cash, (i.e current ratio, quick ratio, net working capital) . PREDICTING CORPORATE BANKRUPTCY USING MULTIVARIANT DISCRIMINATE ANALYSIS (MDA), LOGISTIC REGRESSION AND OPERATING CASH FLOWS (OCF) RATIO ANALYSIS: A Cash Flow-Based Approach By. BANKRUPTCY USING MULTIVARIANT DISCRIMINATE ANALYSIS (MDA), LOGISTIC REGRESSION AND OPERATING CASH FLOWS (OCF) RATIO ANALYSIS: A Cash Flow-Based Approach Christopher Scott Rodgers Golden Gate. Financial Crisis in the Late 2000's 2 2 4 Financial Failures 2010 and beyond 2 3 Traditional Financial Ratio Analysis 2 4 Ratio Analysis as a Predictor of Bankruptcy 2 5 Weaknesses of Accrual-Based