Predicting Industrial Bond Ratings with a Probit Model and Funds Flow Components

James A Gentry, David T Whitford and Paul Newbold

The Financial Review, 1988, vol. 23, issue 3, 269-86

Abstract: This study uses an n-chotomous multivariate probit model with cash-based funds flow components and financial ratios to predict industrial bond ratings. The n-chotomous probit model provides superior information for evaluating the bond classification process. The model determines the probabilities of a bond being rated in one o f three risk classes. New and reclassified bond rating by Moody's in 19 83 provide the information base for the model that is used to predict 1984 ratings. Initially, the classification and predictive results were slightly lower than previous studies. A careful analysis of the probability distributions showed that the results were close to being correct in over 90 percent of the cases. Five significant cash flow components in predictive bond ratings of reclassified issues were inventories, other current liabilities, dividends, long-term financing, and fixed coverage charges. Likelihood tests indicated that both ratios and funds flow components contributed information that significantly improved the ability of the n -chotomous multivariate probit model to classify new and revised bond ratings. Copyright 1988 by MIT Press.

Date: 1988
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