Taking the Twists into Account: Predicting Firm Bankruptcy Risk with Splines of Financial Ratios

Paolo E. Giordani · Tor Jacobson · Erik L. von Schedvin · Mattias Villani

61 citations0/0 files storedJournal of Financial and Quantitative Analysis

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Financial Distress and Bankruptcy Prediction Corporate Finance and Governance Corporate Insolvency and Governance

Abstract

Abstract We demonstrate improvements in predictive power when introducing spline functions to take account of highly nonlinear relationships between firm failure and leverage, earnings, and liquidity in a logistic bankruptcy model. Our results show that modeling excessive nonlinearities yields substantially improved bankruptcy predictions, on the order of 70%–90%, compared with a standard logistic model. The spline model provides several important and surprising insights into nonmonotonic bankruptcy relationships. We find that low-leveraged as well as highly profitable firms are riskier than those given by a standard model, possibly a manifestation of credit rationing and excess cash-flow volatility.

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References

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