Financial and Non-Financial Variables as Long-Horizon Predictors of Bankruptcy

Abstract

Reviews on financial distress prediction models indicate that these techniques give highly reliable estimates of probabilities of default (PDs) and loss given default (LGD) only for relatively short horizons, rarely beyond two years. Major stakeholders, e.g. investors and bank risk and capital analysts, therefore, have such models sanctioned by portfolio managers and regulators for the same short horizons; for example, the Basel Committee on Banking Supervision recommends PD and LGD estimates for one year. This is especially the case when financial variables make up the sole or primary estimates, and only a bit longer reliable estimators when these models include non-financial variables as additional early warning signals. Beyond three years, such models, regardless of their structure, rarely give reliable estimates, perhaps not much better than flipping a coin. The objective of this study is to assess the predictive ability of both financial and non-financial variable constructs for longer term horizons of up to ten years based on rigorous post-development distress and non-distress financial events in the Finnish environment. Our model, built with cross-section data from 2003, analyses results for 2004-2013. Results show that measures of solvency, turnover, industry risk, payment behaviour, and board member characteristics can be significant predictors of bankruptcies for as long as ten years. The most accurate long-range prediction results combine financial and non-financial variables. Subsequent tests should attempt to extend such models in a multi-country setting, whether or not bankruptcy regimes are similar across national borders.