Predicting corporate bankruptcy using multivariant discriminate analysis (MDA), logistic regression and operating cash flows (OCF) ratio analysis A Cash Flow-Based Approach

Predicting corporate bankruptcy using multivariant discriminate analysis (MDA), logistic regression and operating cash flows (OCF) ratio analysis A Cash Flow-Based Approach

PREDICTING CORPORATE BANKRUPTCY USING MULTIVARIANT DISCRIMINATE ANALYSIS (MDA), LOGISTIC REGRESSION AND

OPERATING CASH FLOWS (OCF) RATIO ANALYSIS:

A Cash Flow-Based Approach

By

Christopher Scott Rodgers

for Golden Gate University San Francisco, CA

UMI Number 3459530

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DISSERTATION

Title: PREDICTING CORPORATE BANKRUPTCY USING MULTIVARIANT

DISCRIMINATE ANALYSIS (MDA), LOGISTIC REGRESSION AND

OPERATING CASH FLOWS (OCF) RATIO ANALYSIS:

A Cash Flow-Based Approach

Christopher Scott Rodgers

Submitted in Partial Satisfaction

of the requirements for the degree of Doctor of Business Administration

AGENO SCHOOL OF BUSINESS GOLDEN GATE UNIVERSITY

Hamid Shomali, Ph.D

Miro Costa, Ph.D David Hua, Ph D

DATE: May 2011

PREDICTING CORPORATE BANKRUPTCY USING MULTIVARIANT

DISCRIMINATE ANALYSIS (MDA), LOGISTIC REGRESSION AND

OPERATING CASH FLOWS (OCF) RATIO ANALYSIS:

A Cash Flow-Based Approach

Christopher Scott Rodgers

Golden Gate University, 2011

Abstract

In this paper, we will discuss current solvency evaluation methods, explore their inherent weaknesses and propose a cash flow-based alternative that may be more effective m identifying candidates that are susceptible to financial failure We believe this research will benefit corporate business managers of both public and private firms m helping them to identify and to take constructive action to correct potentially crippling situations We also believe it will be of value to equity and debt investors, by providing them with more timely and accurate analysis for investment decisions Lastly, it should be of

value to auditors in assessing a firm ability to continue

as a Agoing concern' and issuing opinions

I would especially like to thank my committee, Dr Hamid Shomali, Dr Miro Costa, and Dr David Hua for their direction, assistance and support

I would also like to thank Dr Nabil Rageh, my program director for his understanding and consideration of the circumstances I faced while on this journey

I would also like to dedicate the substance of this work in loving memory of my father, Garland, who saw in me what I could not see in myself

Without the help of the aforementioned entities, none

of this work would have been possible

2 2 2 Financial Crisis in the Early 2000's

2 2 3 Financial Crisis in the Late 2000's

2 2 4 Financial Failures 2010 and beyond

2 3 Traditional Financial Ratio Analysis

2 4 Ratio Analysis as a Predictor of Bankruptcy

2 5 Weaknesses of Accrual-Based Ratios

2 6 Growth Rates and Insolvency

2 7 Analyzing the Statement of Cash Flows

2 8 Capital Structure and Insolvency

2 9 Quarterly Versus Audited Financial Statements

2 10 Cash Flow-Based Ratios and Analysis

0 Methodology

3 1 The Scope of the Study

3 1 1 The Bankrupt Sample

3 1 2 The Non-Bankrupt Sample

3 2 Procedures for Analysis of the Financial Statements

3 2 1 Cash Flow-Based Ratios Used in the Study

3 2 2 Calculations and Adjustments Employed

3 3 Statistical Methods Employed

3 3 1 Using Traditional Regression Analysis

3 3 3 Expected Contributions of the Methods Selected

4 1 Results of Hypothesis Testing

4 1 1 Results of Testing Hypothesis 1

4 1 2 Results of Testing Hypothesis 2

4 1 3 Results of Testing Hypothesis 3

4 2 Testing the Holdout Sample

4 2 1 Testing Using Descriptive Statistics

4 2 2 Testing Using the T-Statistic

4 3 The Z-Score Ratios and Their Justification

5 0 Conclusions and Recommendations

5 1 Conclusions Drawn from the Study

5 2 Recommended Use of Study Results

5 3 Suggestions for Future Research

5 3 1 Further Z-Score Testing of Financial Institutions

5 3 2 Testing Solvent Periods of Bankrupt Sample

5 3 3 Development of a Hybrid Score

5 3 4 Testing Market Indexes Components with Z-Score

5 3 5 Testing Our Model Against Altman's Z-Score

5 4 In Closing

l_AIIIUIl3 • • • • • a a a a • • • • • • a • • • • aaa • • • • a

Exhibit 1 List of Bankrupt Companies

Exhibit 2 List of Non-Bankrupt Companies

Exhibit 4 MDA Run (37 Ratio Tested, All Companies)

Exhibit 5 MDA Test Results 37 Ratios-80 Companies

Exhibit 6 MDA Test Results 30 Ratios-80 Companies

Exhibit 7 VIF Run (Top Five Ratios)

Exhibit 8 Logistic Regression Run (Top Five Ratios)

Exhibit 9 Z-Scores for Bankrupts Firms (Six Quarters)

Exhibit 10 Z-Scores for Non-Bankrupt Firms (Six Quarters)

Exhibit 11 Original Non-Bankrupt Sample vs Original Bankrupt Sample Exhibit 12 Summary of Z-Score Fails

Exhibit 13 Z-Scores for Hold Out Samples

Exhibit 14 Original Bankrupt Sample vs Bankrupt Hold Out Sample

Exhibit 15 Original Non-Bankrupt Sample vs Non-Bankrupt Hold Out Sample Exhibit 16 Bankrupt Hold Out Sample vs Non-Bankrupt Hold Out Sample

References

PREDICTING CORPORATE BANKRUPTCY USING MULTIVARIANT

DISCRIMINATE ANALYSIS (MDA), LOGISTIC REGRESSION AND

OPERATING CASH FLOW (OCF) RATIO ANALYSIS:

A Cash Flow-Based Approach

Chapter 1: Introduction

1 1 Objectives of the Study

In this paper, we will discuss current solvency evaluation methods, explore their inherent weaknesses and propose a cash flow-based alternative that may be more effective in identifying candidates that are susceptible to financial failure We believe this research will benefit corporate business managers of both public and private firms in helping them to identify and to take constructive action to correct potentially crippling situations We also believe it will be of value to equity and debt investors, by providing them with more timely and accurate analysis for investment decisions Lastly, it should be of value to auditors in assessing a firm's ability to continue

as a 'going concern' and issuing opinions

In order to accomplish these objectives we will be evaluating financial statements using ratios derived primarily from cash flow statement data Our initial

samples will include 30 of the largest corporate bankruptcies that have occurred in the last 20 years and 30

of the best performing firms based on their five-year return to stockholders Cash flow-based ratios will be calculated for these 60 firms then statistically evaluated, first using backward-regression, and then re-evaluated using logistic regression We intend to develop a z-score

by using the coefficients determined by logistic regression then retesting both samples to evaluate how accurate and effective the model is in properly classifying the firms as either bankrupt or non-bankrupt We will then retest the model using a holdout sample of ten bankrupt and ten non-bankrupt companies to further validate its effectiveness

We believe that the z-score developed in this study will be effective in identifying and classifying 'at risk' companies and will assist managers, creditors and evaluators as a screening tool for solvency We further believe this tool, along with other analysis, can lead to better solvency and risk assessment decisions

1 2 Background

Twenty of the largest corporate bankruptcies in U.S history have occurred since 1987 (bankruptcydata.com) Although some of these business failures, such as General

Motors, K-Mart and United Airlines, were telegraphed through press releases and careful analysis of their financial statements and well anticipated by creditors and investors alike, others, such as Enron, Global Crossing and WorldCom, slipped below the radar, avoiding detection until after their public announcements This inability of traditional analysis to detect these massive failures has cost investors and creditors billions of dollars and weakened the public's faith in the soundness of the securities analysis industry and other watchdog institutions responsible for keeping the public educated and informed (Anand, 2007)

Chapter 2: Review of Literature

2.1 Bankruptcy * An Overview

The act of declaring bankruptcy is typically the final step

in a series of managerial miscalculations, oversights and failed strategies (Bhandari & Weiss, 1996) When these management failures are combined with adverse external events, extensive degrees of insolvency can result, jeopardizing and in some cases terminating the potential long-term existence of a previously productive and solvent entity (ibid) Most analysts agree that the events that lead up to insolvency do not happen overnight and in hindsight, careful analysis of their past performance is generally sufficient in uncovering warning signs that may have been missed by most, if not all, of private and public analysts (Muro, 1998)

In 1991, Dun and Bradstreet (D&B) reported that 41% of corporate bankruptcies in the United States were attributed

to economic factors driven by forces outside of the influence and control of the average firm These factors manifest themselves in the form of industry weakness and insufficient profit margins, and are commonly induced by changes in interest rates, competition, government regulation and weak economic growth (ibid)

D&B also cited that finance factors, such as heavy operating expenses and insufficient capital as the second most common causes at 32.5% They observed that some firms actually grow themselves into insolvency by failing to secure adequate sources of capital or by losing control of their expenses and efficiency ratios through ineffective asset and liability management

Experience factors, such as lack of business knowledge and management experience were third at 20.6% These failures may also be attributed to excessive growth and insufficient planning and are characterized by entering new markets prematurely, promoting underqualifled personnel from within, or failing to seek professional assistance when required (ibid)

The D&B study noted neglect factors (2 5%), such as poor work habits and business conflicts can also be a sign

of management failure Firms that are too immature or too complacent can fall into this category D&B also cited fraud (1.2%), disaster (1.1%), and inappropriate strategy (1.1%) as minor factors D&B also observed that over 50%

of bankrupt firms were over 5 years old at the time they initially filed for protection from creditors, suggesting that age might not be a critical factor

Most distressed firms do not become bankrupt, (Hill and Perry, 1996) In some cases the cause of financial distress is temporary allowing the firm to file a reorganization plan and continue operations or merge with another, more solvent firm, (Gilbert, Menon, & Schwartz, 1990) In other cases, the causes were determined to be permanent in nature and the firms were liquidated in order

to satisfy some, if only a very few of the firms' formal stakeholders and creditors (Moyer, McGuigan, & Kretlow 1998)

Before firms are forced to seek protection from their stakeholders and creditors in the form of bankruptcy, most firms experience the identifiable stages commonly known as technical insolvency, legal insolvency and default Giroux and Wiggins (1983) observed that common business failures begin with lower than expected operating results and the reduction or elimination of dividends Flagg and Giroux, (1991), identified and investigated four potential overt symptoms of financial distress, namely dividend reductions,

"going concern" qualified opinions, debt restructuring problems, and violations of debt covenants (ibid) These events may be considered minor or temporary at first, until they are followed by net losses and negative changes in

operating cash flow Reduction in bond and other credit ratings followed by deteriorating operating results may also be precursors to debt accommodation and default (ibid)

Bathory (1984) identified three distinct classifications of financial distress; acute, chronic, and terminal In acute insolvency cases, the firms past performance had been considered satisfactory until these firms experienced periods of insufficient cash to meet its short-term financial obligations, either through the inability to collect receivables or to secure short-term sources of credit In contrast, the chronically insolvent firms had displayed unsatisfactory or declining performance for years These firms have difficulties meeting mid- to long-term financial obligations and over rely on trade credit and collateralizing their assets Terminally insolvent firms, like chronically insolvent firms display unsatisfactory or declining performance, but are now unable

to fund permanent changes in their balance sheet, have misaligned cash-flow patterns and may only be in business because they are considered 'too big to fail' or a 'national interest' (ibid)

Bathory attributes poor management, unprofitable subsidiaries, divisions or product lines, as well as cyclical, economic and legal-political factors as causes for acute insolvency and poor credit control, low or eroding profit margins and slow asset turnover as causes for chronic and terminal insolvency

Although most traditional analysis attempts to identify these causes and symptoms by using accrual-based analysis methods, the entrance into each of these stages may be more of a result of inadequate operating cash flow rather than a lack of accrued income and profit It is not unusual for a troubled firm to have positive profit margins and still be unable to meet its current cash-flow needs Zeller and Stanko (1994) demonstrated that accrual-based analysis occasionally failed to reveal the severe liquidity problems that can lead to corporate failure

2.2 Financial Failures in the United States

Financial failure over the past 30 years has been driven primarily by economic cycles, deregulation, technological innovations, and in some cases financial mismanagement and fraud (Hamilton & Micklethwait, 2006)

2 2.1 Financial Failures (1980 to 1999)

The majority of financial failures in the 1980's were due to deregulation of the Airline and the Savings and Loan Industries and federal income tax law changes (Sornette, 2003) Airline industry deregulation forced airlines to become more competitive and although it led to more competition and lower airfares, it changed the operating environment severely for the larger U.S carriers (Viscusi, Vernon & Harrington, 1995) Most foreign carriers were not affected by the U.S regulations and many had their operating costs highly subsidized by their home governments (Hanlon, 2007) Shortly afterwards, several major U.S carriers, including Pan Am, Eastern, Continental, America West and Trans World filed for bankruptcy protection along with dozens of smaller U.S airlines (Patashnik, 2008)

Deregulation of the Savings and Loan Industry allowed S&L's to compete for deposits with commercial banks by offering a wider array of savings products as well as expanding their lending authority (Berman & Irons-Georges, 2008) As a result, S&L's became more aggressive in their lending policies and in securing funds (Calavit, Pontell & Tillman, 1997) This strategy led to a mismatch of long-term assets being funded by short-term liabilities (ibid)

Real estate prices soared as investors and speculators began buying up multiple properties, driving prices and interest rates even higher (ibid)

Then in 1986, tax reform legislation changed the real estate investment environment by limiting federal income tax write-offs for private individuals' associated passive investments, leaving many investors with negative after tax cash flows on their rental properties (Berman & Irons-Georges, 2008) As defaults on mortgages began to increase, the value of the underlying assets began to fall (ibid) Soon the S&L's were being required to repurchase their underperforming loans (ibid) Investors in mortgage-based securities began to enforce higher quality standards for conventional loans and many S&L's were being required

to portfolio their loans, tying up valuable funds (ibid) Desperate to find new sources of funds, the S&L's began to offer more exotic savings products to their customers This included high-yield derivative products also known as junk bonds (Calavita, Pontell & Tillman, 1997) Junk bond king, Michael Milken, Charles Keating, and Drexel Burnham transformed Lincoln Savings & Loan from a home mortgage leader into a land developer, junk bond originator and leveraged buy-out company (McCauley, Ruud & Iacono, 1999)

Other funding-starved S&L's began to adopt the Lincoln model and when the bottom fell out, nearly 25% of the S&L's

in the United States had disappeared and with them, the life savings of thousands of depositors (Canterbery, 2006)

2.2.2 The Financial Crisis in the Early 2000's

Most analysts agree that the financial crisis of the early 2000's were due to corporate greed and terrorism (Matulich & Currie, 2009) It began with the 'Dot.com' bust, was exacerbated by the corporate scandals of the early 2000's, and climaxed after 9/11 The unprecedented rise in stock prices in the late 1990's created unrealistic expectations of many stockholders and corporate executives (Sornette, 2003) Even after the market crash, many corporate executives, in order to ensure stable and even increasing stock prices, 'cooked the books' (Matulich & Curry, 2009) Even CPA firms, like Arthur Anderson, succumbed, realizing they could profit more from consulting than auditing, top management required their auditors to find ways to 'make it work' (ibid) Dennis Kozlowski, the former chairman of Tyco was accused and convicted of overstating profits and inappropriate use of corporate funds (Markham, 2006) Adelphia Communications, WorldCom

and Enron Corporation filed for bankruptcy protection shortly after their accounting scandals were reported, leading to three of the largest bankruptcies in United States history (Hamilton & Micklethwait, 2006)

Just when it appeared that a major global financial catastrophe could be avoided, the 9/11 terrorist attacks occurred and again the financial markets around the world tumbled Shortly afterwards, United and US Airlines filed for bankruptcy protection Retail giant K-mart and insurance conglomerate Conseco also failed It would take

at least another three years before confidence in the market and its oversight would be effectively restored (Anand, 2007)

2.2.3 The Financial Crisis in the Late 2000' s

The financial crisis that began in 2007 is believed by many economists to be the worst global crisis since the Great Depression of the 1930's (Roubini, 2009) Its origins can be traced back to the 1999 repeal of the Glass-Steagall Act of 1933 that previously prohibited depository banks from engaging in speculative activities commonly reserved for investment banking companies (ibid) This fundamental change in the banking environment led to commercial banks and federal mortgage entities having to

compete with Wall Street for quality mortgages This increase in capital and competition led to a lowering of standards, excessive mortgage liquidity and a housing bubble that began to collapse in 2006 (O'Brien, 2009) Eventually, many of the subprime borrowers began to have problems making their mortgage payments, leading to default and eventually foreclosure (ibid) Once the value of the underlying assets that securitized the mortgages fell below the value of the securities, defaults began to accelerate and the securities held by the banks and other mortgage investment entities declined in value as well (Muolo & Padilla, 2008) This valuation issue was exacerbated by the 'mark-to-market' rule that required banks to report their mortgage-backed securities at the lower of their face

or market value (Barth, 2009) This adjustment to the value of the securities greatly reduced the value of bank assets and restricted a bank's ability to lend and maintain the margin requirements monitored by the Federal Reserve This lack of margin led to a global liquidity crisis that further contributed to the downfall of major commercial banks world-wide (ibid) Eventually, the troubles of Wall Street spilled over onto Main Street The liquidity crisis led to a drying up of credit and adversely reduced

consumers and businesses ability to secure credit for large-ticket purchases and acquisitions (Muolo & Padilla, 2008) The corresponding reduction of consumer and business demand led to reductions in production and layoffs (ibid) This in turn led to more defaults, further write-down of bank assets and more financial failure (ibid)

In the United States, Lehman Brothers, Indy Mac Bancorp, Washington Mutual, and many other financial institutions collapsed Later General Motors, Chrysler and retailers began to fail In an attempt to stem the tide, governments of capitalist nations have taken unprecedented actions to partially or completely take-over failing institutions (O'Brien, 2009) At the time of this paper, the issue still appears to be somewhat stable, but yet unresolved

2.2.4 Financial Failures 2010 and Beyond

Since 2010, most of the financial failures have been related to economic cycles and have included retailers like Blockbuster, Borders and several small to mid-sized banks Analysts are divided as to whether recent government reforms and oversight will reduce the likelihood of future financial meltdowns, but most agree that Sarbanes-Oxley, Dodd-Frank and increased oversight by the Security and

Exchange Commission (SEC) should provide some additional protections to the investing and consuming public (Sweeney, 2011)

The Sarbanes-Oxley Act, also known as the 'Public Company Accounting Reform and Investor Protection Act' was passed into law in 2002, shortly after the Enron, WorldCom, Tyco, Adelphia and Peregrine Systems scandals weakened the public confidence in the U.S securities markets (Green, 2004) The law set new and enhanced standards for all U.S public boards, corporate management and public accounting firms (ibid) The law contains eleven specific mandates and requirements for public reporting, including the establishment of a Public Company Accounting Oversight Board (PCAOB), enhanced standards for auditor independence, individual responsibility for 'principle officers', enhanced financial disclosures, disclosure of conflicts of interest and codes of conduct for analysts, protection for 'whistle-blowers', and criminal and financial penalties for fraud, destruction or alteration of financial records, and interfering with government investigations (Anand, 2007) The three provisions that are expected to have the most profound effect on the issuance of fraudulent financial statements are the Auditor Independence, Corporate

Responsibility and Corporate Fraud Accountability Provisions (Green, 2004)

The Public Company Accounting Oversight Board (PCAOB) was established to provide independent oversight of public accounting firms providing audit services (Anand, 2007)

In the past, CPA firms were expected to monitor and regulate themselves and to adhere to a rigid code of ethics (ibid) Arthur Anderson and its participation in the Enron, WorldCom and Global Crossing scandals has made this previous assumption of self-regulation inoperable (ibid) The PCAOB provision creates a central oversight board responsible for registering auditors, defining specific processes and procedures for compliance audits, inspecting and policing conduct and quality control and enforcing compliance with the mandates of Sarbanes-Oxley (Green, 2004)

The jury is still out with regards to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which was passed in the aftermath of the subprime mortgage crisis (Sweenney, 2011) The law is expected to strengthen the ability of government investigators with new rules and penalties in the effort to target and uncover 'white-collar' crime and rewards for 'whistle-blowers' who are

willing to come forward and cooperate with government investigators (ibid) The law contains sixteen titles, creates 243 new rules, conducts 67 studies and requires the issuance of 22 periodic reports (DavisPolk, 2010) The stated purpose of the law is:

"to promote the financial stability of the United

States by improving accountability and transparency in the financial system, to end "too

big to fail", to protect the American taxpayer by

ending bailouts, to protect consumers from

abusive financial services practices, and for

other purposes" (HR 4173)

The law gives the Federal Government the power to 'promote market discipline' and oversee the liquidation of bank assets in receivership It also enumerates the authority of the Federal Reserve, FDIC and the Comptroller

of the Currency, introduces significant regulation with regards to hedge funds and similar investment intermediaries, establishes a 'Federal Insurance Office', distinguishes between banking and nonbank financial transactions, requires more transparency and accountability from Wall Street, enhances the role of the Federal Reserve with regards to payments, clearing and settlement, increases the role of government in the area of investor protection, improves oversight of credit rating agencies, creates the Bureau of Consumer Financial Protection,

provides for the repayment of TARP (Trouble Asset Relief Program) funds, and increases regulation and oversight of mortgage providers and targets 'predatory' lending violators (HR 4173)

Detractors of the law suggest it is overkill; that many of the provisions are already covered in Sarbanes-Oxley (Sweeney, 2011) They believe the law can create a 'draconian and corrosive atmosphere' (ibid) There are also concerns that the law places excessive reporting requirements on small and midsized financial institutions (Isaac & Smith, 2011)

It may be several years before the impact of these overhauls will truly be known But if the past has taught

us anything, it's that laws, no matter how noble and comprehensive, can be circumvented and compromised Due diligence will always be the responsibility of the stakeholders

2 3 Traditional Financial Ratio Analysis

In order to inform and protect private investors and creditors, publicly traded corporations must abide to strict reporting standards and scrutiny from government regulators and private analysts (Fraser & Ormiston 1998) Publicly traded firms are required to file quarterly (lOQs)

and annual (lOK's) operational and financial statements with the Securities and Exchange Commission (SEC) They are also required to provide to the public, externally audited financial statements annually and report any trading activity engaged in by management and other 'insiders' (ibid)

Most of the credit and liquidity assessment of firms presented to the public is derived by employing traditional financial ratio analysis, which in most cases is accrual-based and focuses on profits calculated using generally accepted accounting principles (GAAP) rather than cash generated from operations

Most liquidity ratios are derived by evaluating the relationship between current assets and current liabilities Under this analysis, all current assets are considered to be essentially as liquid as cash In the current ratio all current assets are included and only inventory is excluded when calculating the quick ratio Increases in current assets are generally considered positive especially when matched with equal or lesser increases in current liabilities Under GAAP, it is possible that a firm could be reporting large profits while its cash reserves are drying up (Bragg, 2007)

Efficiency or turnover ratios are used to assess a firm's effective use of assets and payables as they relate

to average daily sales, cost of goods sold and credit purchases

Financial leverage ratios attempt to assess a firm's borrowing capacity, ability to make interest payment and to crudely estimate financial risk (Higgins, 2001)

Profitability ratios measure a firm's ability to maintain or to grow its margins at its gross, operating and net profit levels, while market ratios essentially attempt

to validate a firm's market value and stock price as a function of earnings, book value and payment of dividends

Coverage ratios such as times-interest-earned (TIE) and fixed-charge-coverage ratios use earnings before interest and taxes (EBIT) to determine a firm's ability to meet the minimum expectation of its creditors, while market ratios such as price-to-earnings (P/E) and the dividend pay-out ratio are calculated using earnmgs-per-share (EPS) Both of these proxies may have little or no relationship to the actual cash flow generated by current

or future operational activities

2.4 Ratio Analysis as a Predictor of Bankruptcy

In the mid-1930's, financial ratio analysis was in its infancy Smith and Winakor (1935) observed that failing firms had substantially weaker ratios than successful firms In 1966, Beaver conducted one of the most intensive studies in an attempt to identify correlations between individual ratios and financial distress using a univariate analysis approach that laid the foundation for most contemporary correlation studies Beaver's findings suggested that several ratios could be effective in identifying failing firms as early as five years prior to their actual failure

Following up on Beaver's study, Altman (1968) employed

a multivariant discriminate analysis (MDA) model to identify, rank and weight financial ratios that were strongly correlated to recent corporate failures His ex-ante study focused primarily on manufacturing firms and was successful in predicting bankruptcies 12 months in advance 95% of the time and two years prior to failure 72% of the time, (Gallmger and Poe, 1995) The five ratios that Altman determined to be the most effective were; Working Capital to Total Assets (XI), Retained Earnings to Total Liabilities (X2), EBIT to Total Assets (X3), Market Value

of Equity to Total Liabilities (X4), and Net Sales to Total Assets (X5) MDA suggested a weighting of the ratios as 1.2(X1) + 1.4(X2) + 3.3(X3) + 0.6(X4) + 1.0(X5) Once the results were combined, scores of 3.0 or better suggested a healthy firm, scores between 1.81 and 2.99 suggested firms with a questionable financial status, while firms with scores below 1.81 were determined to have a good chance of financial failure in the next two years This model is commonly known as Altman's Z-Score Model

Since the introduction of the Altman model, researchers in other countries have modified the Z-Score model to adapt it to their unique accounting procedures and bankruptcy laws, i.e Wang and Campbell, (2010, China), Lugovskaya, (2009, Russia), Lifschultz and Jacobi, (2010, Israel), Lu and Chang (2009, Taiwan), and Charitou, et al, (2004, United Kingdom) Chuvakhin and Gertmeman (2003) employed Altman's model and demonstrated its effectiveness

in predicting WorldCom's Collapse Its z-scores for 1999

2000 and 2001 were 2.697, 1.274 and 0.798; well below the Altman cutoff

2.5 Weaknesses of Accrual-Based Ratios

The inherit weaknesses of accrual-based ratios may be

in their accumulation and reporting formats Balance sheet

data is static and measures only a single point in time Income statement data includes many arbitrary non-cash allocations such as depreciation and amortizations (Ryu & Jang, 2004) Capital asset and equity balances are required under GAAP to be reported at their historical costs, which is most likely not reflective of current market values and represent monies that have already been spent, (Higgins, 2001) Mills and Yamamura (1998) concluded that cash flow information may be more reliable

in determining liquidity than balance sheet information that implicitly suggests that other current assets are as liquid as cash, (i.e current ratio, quick ratio, net working capital)

Used in isolation, liquidity ratios can produce misleading expectations For example, a substantial increase in accounts receivables and inventory without a relative increase in sales may actually suggest an inefficient build up in these accounts which, if not addressed, may eventually lead to future write-downs and corresponding losses rather than an improvement in liquidity In order to be meaningful, liquidity ratios should be used in conjunction with efficiency ratios Ratios that use total assets or equity as numerators or

denominators may also produce misleading results due to the fact that they are based on historical data rather than current market valuations of these balances For example, assets such as buildings may be worth 5 to 10 times their original purchase price, resulting in the reporting of higher returns on assets (ROA) and overstated debt-to-asset ratios Common stock in the equity section reflects the price the stock was sold for initially This fact could lead to overstated returns on equity (ROE) and overstated debt to equity ratios Newer firms may appear to be less efficient and less profitable than older firms do, but also may appear to be more solvent This problem is beyond the scope of this paper, but signifies some of the inherent weaknesses associated with tradition analytical methods

2.6 Growth Rates and Insolvency

As noted earlier, some firms can actually grow themselves to insolvency Rapid growth, one that exceeds the firm's sustainable growth rate, demands increasingly larger amounts of capital This demand for capital can eventually force a firm into a more risky capital structure

in the event it is unable to increase its efficiency or its margins Increases in sales are generally accompanied by increases in assets Since total assets must equal total

liabilities plus equity, any increase in assets must be accompanied by an equal increase in liabilities or equity

or both (Ross, Westerfield, & Jaffe, 2002) Since most firms find it is not only easier, but in most cases, more desirable to incur additional debt rather than to raise capital in the equity market, they are more likely to finance growth with debt (Myers 1984) A firm that grows

at a rate compatible with its sustainable growth rate will generally be able to finance its growth without having to change its capital structure, profit margins or asset turnover ratio Firms that exceed this growth speed limit may eventually find its funding sources limited or exhausted and in most cases too costly to obtain

The accounting sustainable growth rate can be estimated by multiplying a firm's return on equity (ROE) by its retention ratio (RR) (Higgins 2001) A firm's retention ratio is the reverse of its dividend pay-out ratio and can be calculated as one (1) minus the dividend pay-out ratio ROE can be broken up into its Du Pont equivalents; profit margin (Nl/Sales) times its total asset turnover ratio (Sales/Total Assets) times its equity multiplier (Total Assets/Total Equity) Our concern with

this formula is that it assumes cash will increase at the same rate as retained earnings

2.7 Analyzing the Statement of Cash Flows

The cash flow statement is broken up into three sections; cash flows provided by operating activities, investing activities and financing activities (SFAS 95)

Cash flows provided by operating activities (CFO) include cash from the sale of goods or services, cash received from interest and dividends earned, less cash payments for inventory, operating expenses, employee salaries, operating supplies, interest on debt and taxes

Cash flows provided by investing activities (CFI) include proceeds from the sale of long-lived assets, debt

or equity securities, loan payments received, less any acquisition of long-lived assets, purchases of debt or equity securities of other entities, and loans made to others

Cash flows provided by financing activities (CFF) include proceeds from borrowing or issuing stock, less any repayments of debt principle, repurchase of stock or payment of dividends

Mulford and Comiskey (1996) also observed that changes

in operating cash flow were influenced by three factors;

revenue growth, changes in profit margins, and changes in operating efficiency By isolating the change attributable

to each of these factors, they determined that the quality and trend of the operating cash flows could be more accurately assessed

Comiskey and Mulford (1993) identified a relationship between a firm's life cycle, cash flows and net income They observed that start-up firms generally have negative cash flows from operations and investing activities, and positive cash flows from financing activities This is not unusual, because start up firms are generally building up inventories, capturing new customers and purchasing long-lived assets while financing these activities with external sources of capital

Once a firm moves into its growth phase, it may begin

to show an improvement in operating cash flow, positive net profits, but continue to maintain a negative cash flow from investing activities and a positive cash flow from financing activities since it is still adding capacity and consuming external capital

Once a firm matures, it should continue to show a positive cash flow from operating activities, slower sales,

profit growth, and investment in assets, while beginning to pay off some debt, repurchase stock and pay dividends

As a firm moves into its decline phase, profits may become negative as operating cash flows may still be positive but may also begin to decline Investing cash flow turns positive as the firm begins to sell off its excess capacity and financing outflows increase as excess retained earnings are used to retire debt, buy back stock and accelerate dividends disbursements

Firms in financial distress, generally display dramatically different cash flow patterns Firms in reorganization will generally have a negative cash flow from operations, a positive cash flow from investing activities and a negative cash flow from financing The positive inflow from investing is usually due to the liquidation of excess assets and negative cash flows from financing as they work to satisfy stakeholders Distressed firms will also report negative cash flows from operations and investing, but will still be in the process of raising capital and reporting a positive cash flow from investing activities These may be the most dangerous (ibid)

2.8 Capital Structure and Insolvency

A firm's investment in assets, its type of industry and the markets it chooses to serve can be used to determine its business risk, while how it chooses to finance its assets, determines its financial risk, (Gallinger & Poe, 1995) Healthy firms can modify their capital structures either slowly or quickly, depending on their resources and strategic goals Distressed firms, on the other hand, have fewer options available to them, (ibid) They must sell some of their assets, renegotiate with current lenders, or merge with a stronger firm If these options fail, they may have to seek bankruptcy protection, (ibid)

2.9 Quarterly versus Audited Financial Statements

Most traditional analysis relies on annual financial statements primarily because they have been audited and are therefore are believed to be more reliable than unaudited, quarterly financial statements Baldwin and Glezen (1992) found that there was no statistical evidence to suggest that quarterly financial statements were less accurate than annual financial statements with regards to assessing solvency and went on further to suggest that quarterly statements provided more timely evidence of insolvency than

annually issued statements without a substantial loss of accuracy

2.10 Cash Flow-Based Ratios and Analysis

Cash flows from operations show a firm's ability to finance its operating expenditures, meet its maturing debt obligations, satisfy unforeseen expenditure and take advantage of new business opportunities, (Larson, Wild & Chiappetta, 2006) The establishment of SFAS 95 (1987) requires that the statement of cash flow be included in corporate annual reports Casey and Bartczak, (1985) concluded that the inclusion of cash flow data increased the accuracy of discriminating between potentially bankrupt and non-bankrupt firms Bankers have been employing some degree of cash flow analysis for years in the evaluation of loan candidates (Mills & Bible, 1998) Carslaw and Mills (1991) identified four categories of cash flow analysis that could be effective in determining the health of a firm; solvency and liquidity, quality of earnings, capital expenditures, and cash flow returns Since then, cash flow analysis has been proven effective in evaluating liquidity and solvency as well as assessing the viability of companies as 'going concern' Rujoub, Cook and Hay (1995) found that cash flow data predicted bankruptcy more

effectively than accrual-based data and that using cash flow-based ratios in conjunction with accrual-based ratios was more effective than using accrual-based ratios alone They also concluded that cash flow ratios, by themselves, were useful as a supplement to accrual accounting ratios in predicting corporate failure Mills and Yamaura (1998) demonstrated that cash flow ratios may be a better indicator of liquidity than traditional accrual-based ratios They also concluded that cash flow-based analysis was more effective in evaluating a firm's ability to secure short-term financing and a firm's ability to meet its ongoing financial and operational commitments

Chapter 3: Methodology

3.1 The Scope of the Study

The scope of this study includes the evaluation of 30

of the largest bankruptcies in American history (exhibit 1), which have occurred over the last 30 years and 30 of the best performing publically-traded companies as of March

31, 2010 (exhibit 2 ) , as determined by their 5-year return

to stockholders as reported by Bloomberg (Murphy, 2010) The first group will serve as a proxy for bankrupt firms, while the second group represents non-bankrupt firms Five financial companies were added to the non-bankrupt sample

in order to more closely mimic the bankrupt sample It should be noted that four of these firms would not normally

be included in a non-bankrupt sample due to their subpar financial performance

Financial statement data for the bankrupt companies reflect the last reporting period data released prior to their bankruptcy announcement data An additional five working days were added on to ensure that analysts would have enough time to evaluate the results and make public their findings Financial statement data of non-bankrupt companies were employed based on the most current available

as of February 14, 2011 The non-bankrupt firms suggested