Financial and nonfinancial variables as long-horizon predictors of bankruptcy

Małgorzata Iwanicz-Drozdowska, Erkki K. Laitinen, Arto Suvas and Edward I Altman

Journal of Credit Risk

Abstract: ABSTRACT Reviews of financial distress prediction models indicate that these techniques give;highly reliable estimates of probabilities of default only for relatively short horizons,;rarely exceeding two years. This is particularly the case when financial variables make;up the sole estimate or primary estimates. So far, bank managers have focused on;the one-year probability of default estimation required by Basel capital regulations.;According to an emerging accounting standard (IFRS 9), banks will be obligated;to estimate a probability of default lifetime in order to calculate credit allowances.;Moreover, there is a need to improve communication and transparency between small;and medium-sized private enterprises and suppliers of capital to overcome the problem;of credit rationing, especially in Europe. Thus, it is challenging to search for new tools;to extend the distress or failure prediction period. We assess the long-term (up to ten;years) predictive ability of both financial and nonfinancial variables, paying special;attention to the role of nonfinancial variables. Our study is based on rigorous postdevelopment;distress and nondistress financial events in the Finnish environment. Our model, built with cross-sectional data from 2003, analyzes results for 2004-13 and;shows that measures of solvency, turnover, environmental risk, payment behavior and;board member characteristics can be significant predictors of bankruptcies for as long;as ten years. Our most accurate long-range prediction results combine financial and;nonfinancial variables.

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