What happens with distress prediction when recession comes Nataša Šarlija Faculty of Economics in Osijek Marina Jeger Faculty of Economics in Osijek CQD 2011

Research questions Would the models that were effective during the prosperity be useful during the recession? Croatian Quants Day, 6 May 2011 In the world of privately-owned SMEs, what group of financial ratios becomes dominant after the recession starts? 2

Financial distress prediction models lose their predictive ability over time. (Zavgren, 1985; Holmen, 1988) Financial distress prediction models lose their predictive ability when applied to the new data. (Moyer, 1977) Previous research Financial prediction models based on financial data before and during recession. Focus on privately- owned SMEs. Our research 3 Croatian Quants Day, 6 May 2011

Financial distress We consider the problem of modeling financial distress of privately-owned SMEs. Financial distress is defined as company’s inability to pay a single obligation continuously over the period longer than 90 days in one year. Data set of 1987 privately-owned SMEs. Default rate: Variables include registration data (headquarters info, industry), financial ratios based on financial data from balance sheet and income statement. 2006/ / /2009 4,85%8,12%9,97% 4 Croatian Quants Day, 6 May 2011

Data and Variables Source of data set: Financial Agency (FINA) Sample 2008/ / /2007 Development – healthy companies Development – distressed companies Validation – healthy companies Validation – distressed companies Croatian Quants Day, 6 May 2011

Methodology: Logistic Regression Logistic regression the assumption of LR model is linear relationship between a parameter and the vector of explanatory variables x j : the linear relationship between the logarithm of odds and the vector of explanatory variables results in nonlinear relationship between the probabilty of Y j equals 1 and the vector of explanatory variables: 6 Croatian Quants Day, 6 May 2011

Results (1/4) GroupFinancial ratio p-level Profitability  Operating Revenues/Operating Expenses Liquidity  Long-term Assets/(Equity + Long-term Liabilities) Liquidity  Short-term Liabilities/Total Assets Liquidity  Cash/Total Assets Activity  Sales/Accounts Receivables Activity  Equity/Sales Activity  Sales/Total Assets Profitability  Net Profit/Equity Financial distress model 2006/2007 Ratios marked with red represent those ratios that are relevant only in corresponding model. Ratios marked with green are the ones relevant in all three models. 7 Croatian Quants Day, 6 May 2011

Results (2/4) Financial distress model 2007/2008 GroupFinancial ratio p-level Profitability  Operating Revenues/Operating Expenses Liquidity  Cash/Short-term Liabilities Liquidity  Long-term Assets/(Equity + Long-term Liabilities) Liquidity  Short-term Liabilities/Total Assets Activity  365/Receivables Turnover Activity  Equity/Sales Activity  Sales/Total Assets Leverage  Long-term Liabilities/ Short-term Assets Profitability  Net Profit/Equity Croatian Quants Day, 6 May 2011

Results (3/4) Financial distress model 2008/2009 GroupFinancial ratio p-level Profitability  Operating Revenues/Operating Expenses Liquidity  Cash/Short-term Liabilities Liquidity  Long-term Assets/(Equity + Long-term Liabilities) Liquidity  Short-term Liabilities/Total Assets Activity  Total Revenues/Total Assets Activity  Equity/Sales Activity  (Short-term Assets – Inventory) / Sales Leverage  Equity/Total Assets Profitability  Net Profit/Equity Activity  Total Revenues/Short-term Assets Croatian Quants Day, 6 May 2011

Results (4/4) 10 Croatian Quants Day, 6 May 2011

Discussion & Conclusion (1/2) Economic implications  Alongside the changes and adaptation of everyday business activities to signs of recession, activity ratios gained a bigger share in the prediction model.  Ratios that incorporate equity as a source of funding are more present in the 2008/2009 model.  Five ratio are constant in all three models. 11 Croatian Quants Day, 6 May 2011

Discussion & Conclusion (2/2) Implications related to model development  If economic conditions are stabile, the same model can achieve adequate precision over the years.  If the conditions are changing, the first step would be to change the cut-off policies after which development of the new model follows.  The more adequate solution would be to include macroeconomic variables in financial distress prediction model => FURTHER RESEARCH 12 Croatian Quants Day, 6 May 2011

Thank you for your attention! Croatian Quants Day, 6 May 2011 Questions? Nataša Šarlija Marina Jeger

References (1/3) 1.M. Adnan Aziz, Humayon A. Dar, (2006) "Predicting corporate bankruptcy: where we stand?", Corporate Governance, Vol. 6 Iss: 1, pp Altman, E. I. (1968), "Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy" The Journal of Finance, XXIII. 3.Altman, E.I., Marco, G., Varetto, F., Corporate distress diagnosis: Comparison using linear discriminant analysis and neural networks (the Italian experience), Journal of Banking and Finance 18, pp Balcaen, S., Ooghe, H., (2004) "35 years of studies on business failure: an overview of the classical statistical methodologies and their related problems," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium 04/248, Ghent University, Faculty of Economics and Business Administration. 5.Beaver, W. H. (1966), “Financial Ratios As Predictors of Failure” Journal of Accounting Research, Vol. 4, Empirical Research in Accounting: Selected Studies 1966, pp Chen, K. H., Shimerda, T. A. (1981), “An empirical analysis of useful financial ratios" Financial Management, pp Desai, V.S., Crook, J.N., Overstreet, G.A., A comparison of neural network and linear scoring models in credit union environment, European Journal of Operational Research 95, pp Croatian Quants Day, 6 May 2011

References (2/3) 8. Desai, V.S., Conway, D.G., Crook, J.N., Overstreet, G.A., Credit scoring models in credit union environment using neural network and generic algorithms, IMA Journal of Mathematics Applied in Business & Industry 8, pp Galindo, J., Tamayo, P., Credit Risk Assessment Using Statistical and Machine Learning: Basic Methodology and Risk Modeling Applications, Computational Economics 15, pp Harrel F. E. Jr. (2001) Regression modeling strategies with applications to linear models, logistic regression and survival analysis. Springer: Berlin 11. Hendel, I. (1996), "Competition under Financial Distress" Journal of Industrial Economics, Blackwell Publishing, vol. 44(3), pp Holmen, J. S. (1988), “Using Financial Ratios to Predict Bankruptcy: An Evaluation of Classic Models Using Recent Evidence”, Akron Business and Economic Review, Spring, Vol. 19, No. 1, pp. 52 – Mensah, Y. M. (1984), “An Examination of the Stationarity of Multivariate Bankruptcy Prediction Models”, Journal of Accounting Research, Vol. 22, No. 1, pp Moyer, R. C. (1977), "Forecasting financial failure: A re-examination" Financial Management 6 (1), pp. 11–17. ng Research, Spring, pp Croatian Quants Day, 6 May 2011

References (3/3) 15. Ohlson, J. (1980), ”Financial ratios and the probabilistic prediction of bankruptcy”, Journal of Accounting Research, Spring, pp Opler, T. C., Titman S. (1994), “Financial Distress and Corporate Performance” The Journal of Finance, Vol. 49, No. 3, Papers and Proceedings Fifty-Fourth Annual Meeting of the American Finance Association, Boston, Massachusetts, January 3-5, 1994, pp Pinches, G. E., Mingo, K. A., Caruthers, J. K. (1973) “The stability of Financial Patterns in Industrial Organizations,” Journal of Finance, pp. 389 – Yobas, M.B., Crook, J.N., Ross, P., Credit Scoring Using Evolutionary Techniques, IMA Journal of Mathematics Applied in Business & Industry, 11, pp Zavgren, C. V. (1985), “Assessing the vulnerability to failure of American industrial firms: a logistic analysis” Journal of Business Finance and Accounting 12 (1), pp. 19– Zmijewski, M. E. (1984), “Methodological issues related to the estimation of financial distress prediction models” Journal of Accounting Research 22 (Suppl.), pp. 59– Croatian Quants Day, 6 May 2011