Understanding Differences Between Financial Distress and Bankruptcy

Abstract

For the most part, research purporting to address the issue of financial distress has actually studied samples of bankrupt companies. Financial distress and bankruptcy are different. In contrast, this paper starts with a sample of companies that are financially distressed but not yet bankrupt. The sample was obtained by screening the Compustat industry database with a three-tiered identification system. The screen bifurcated companies into financially and non-financially distressed groups. A multi-tiered screen reduces the incidence of mistakenly identifying a non-distressed company as financially distressed. The paper then compares factors indicating the likelihood of future bankruptcies to those indicating future financial distress. To do this, an early warning financial-distress model was developed and compared to a methodologically similar existent model of bankruptcy. The final financial distress model included only one variable present in the bankruptcy model and four new variables. The limited overlap of explanatory factors between the models questions the similarity of financial distress and bankruptcy. Statistical tests lend support to the notion that the bankruptcy process is not just a continuation of a downward spiraling cycle of financial distress. Our hypothesis is that financial distress is something that happens to companies as a consequence of operating decisions or external forces while bankruptcy is something that companies choose to do to protect their assets from creditors.

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