An Empirical Test of Financial Ratio Analysis for Small Business Failure Prediction

Robert O. Edmister

Journal of Financial and Quantitative Analysis, 1972, vol. 7, issue 2, 1477-1493

Abstract: This study develops and empirically tests a number of methods of analyzing financial ratios to predict small business failure. Although not all of the methods and ratios are predictors of failure, many ratio variables are found which do predict failure of Small Business Administration borrowers and guarantee recipients. Using step-wise multiple discriminant analysis with a restriction on the simple correlation of the entering variable with the included variables, a function of independent ratio variables, which is highly accurate in classifying borrowers in the test sample, is developed. Methods of analysis found useful are (1) classification of a borrower's ratio into quartiles relative to other borrowers in the sample, (2) observation of an up- or down-trend for a three-year period, (3) combinatorial analysis of a ratio's trend and recent level, (A) calculation of the three-year average, and (5) division of a ratio by its respective RMA industry average ratio. The discriminant function demonstrates an ability as great as those functions recently estimated for much larger firms. However, the small business function fails to discriminate when only one statement is available, whereas Altman [1] and Beaver [4, 5] show that one financial statement is sufficient for a highly discriminant function for large businesses. This leads the author to qualify his conclusion above with the provision that at least three consecutive financial statements be available for analysis of a small business.

Date: 1972
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