Journal of Small Business Management 2013 ••(••), pp.

••–••
doi: 10.1111/jsbm.12076

Which Characteristics Predict the Survival of Insolvent

Firms? An SME Reorganization Prediction Model
by Maria-del-Mar Camacho-Miñano, Maria-Jesus Segovia-Vargas, and
David Pascual-Ezama

The negative impact of insolvency, especially in small and medium enterprises, informs the
objective of this paper: to study the characteristics of bankrupt firms to achieve a preventive
diagnosis for reorganization by means of artificial intelligence (AI) methodologies such as rough
set and PART methods. The AI models obtained show not only the key variables to predict
insolvency, but also their relations and the critical values. Using only five firm characteristics
(sector, size, number of shareholdings, return on assets, and cash ratio), our model could reduce
delays and costs, since it is able to predict which firms will undergo reorganization or liquidation
before the legal procedure.

there is substantial research on bankruptcy pre-

Introduction
The current economic crisis has revealed the
huge social and economic costs at micro and
macro levels worldwide that can result from
companies falling into financial distress. At the
same time, given the high number of bankrupt
firms, the legal procedure is too long and costly
in many countries and often becomes ineffi-
cient. In general, bankruptcy regulation aims to
preserve as many firms as possible in order to
reduce the negative social, economic, and
financial impact of business failures. However,
due to the current economic crisis and bank-
ruptcy laws, official bankruptcy statistics show
that only a few companies with financial prob-
lems survive. To our knowledge, although
diction, there are no studies focused on the
analysis of company reorganization.
The objective of this paper is to identify the
characteristics of insolvent firms in order to
achieve a preventive diagnosis for reorganiza-
tion, allowing financially distressed companies
to avoid the complex legal bankruptcy process.
To attain this objective, two artificial intelli-
gence (AI) methods are used to analyze a
sample of 1,387 bankrupt Spanish firms listed
by the Commercial Justice Courts during the
year 2010.
Our study contributes to the existing litera-
ture on bankruptcy in several ways. First, by
identifying key characteristics of bankrupt
firms, it may help decision-makers diagnose the

Maria-del-Mar Camacho-Miñano is assistant professor at Department of Financial Economics and Account-

ing II, Complutense University of Madrid.
Maria-Jesus Segovia-Vargas is assistant professor at Department of Financial Economics and Accounting I,
Complutense University of Madrid.
David Pascual-Ezama is assistant professor at Department of Financial Economics and Accounting II,
Complutense University of Madrid.
Address correspondence to: Maria-del-Mar Camacho-Miñano, School of Business Administration and
Economics, Department of Financial Economics and Accounting II (Accounting), Campus of Somosaguas,
Complutense University of Madrid, Campus of Somosaguas, 28223 Pozuelo-de-Alarcón, Madrid, Spain. E-mail:
marcamacho@ccee.ucm.es.

CAMACHO-MIÑANO, SEGOVIA-VARGAS, AND PASCUAL-EZAMA 1

probability of a firm’s survival, avoiding the
hassle of the legal process. In fact, to our
knowledge, there has been no empirical study
about this matter. Second, to reach this diagno-
sis, a sample of bankrupt Spanish small and
medium-sized enterprises (SMEs) is used, and
the study could be useful to SMEs1 in other
countries. Currently, Spain, as many other
nations, has a large number of small enterprises
(about 94 percent of total businesses are small,
only 5 percent are medium-sized, and 1 percent
are large), but reorganization research has paid
little attention to these companies, despite their
importance in national economies. Moreover,
there is no empirical study based on the current
Spanish reorganization proceedings. Although
the sample used is Spanish, our results could
be applied to other nations and bankrupt SMEs
(Laitinen 2011). Third, this study completes
existing research on bankruptcy prediction
based on rough set (RS) and PART methodolo-
gies. When these methods have focused on the
prediction of financial distress, they have com-
pared “healthy firms” with the failed ones (Ahn,
Cho, and Kim 2000; Beynon and Peel 2001;
Diaz, Sanchis, and Segovia 2009; Dimitras et al.
1999; Greco, Matarazzo, and Slowinski 1998;
McKee 2000; Sanchis et al. 2007; Slowinski and
Zopounidis 1995). However, as far as we know,
there is no study about the implementation of
RS and PART methods to address the problem
of bankrupt firms’ reorganization.
The paper is organized as follows. In the
second section the current context of the bank-
ruptcy process is shown. A review of the existing
literature on bankruptcy prediction is displayed
in the third section. Next, taking into account the
most significant figures about reorganized firms
in the Spanish bankruptcy process, the sample is
presented. The RS and PART methodologies
used are shown in the fifth section. Finally, the
main conclusions are highlighted and some
future lines for research are offered.
Context of the Bankruptcy
Procedure
Most countries in the world set up a proce-
dure, usually in court, to manage the financial
1
In fact, the 23 million SMEs in the EU represent 99 percent of businesses, and are a key driver for economic
growth, innovation, employment, and social integration. http://ec.europa.eu/enterprise/policies/sme/index
_en.htm
2
The terms “insolvency,” “business failure,” and “financial distress” are used in the same way: when the firm
has no cash to pay its debts.
2 JOURNAL OF SMALL BUSINESS MANAGEMENT
distress of a company, and this is usually called
bankruptcy. A generally accepted definition of
a financially distressed firm is a company that
cannot meet financial obligations due to liabili-
ties that are disproportionately larger than its
assets and/or chronically suffers from large
accumulated losses (Xu and Wang 2009). In
general, there are different outcomes of finan-
cial distress. These outcomes include bank-
ruptcy, dissolution, liquidation, merger, or
sustaining operations as long as possible.
Bankruptcy is a legal process designed to solve
the financial problems of insolvent firms that
are on the brink of financial ruin.
In general, the problems of financially dis-
tressed companies are an interesting topic of
research because failed businesses2 not only
generate huge economic losses for shareholders
and creditors but also burden nations with
immense social and economic costs (Wu 2010).
The current economic crisis makes this problem
worse. Additionally, bankruptcy laws affect the
development of national entrepreneurship (Lee
et al. 2011) because there is an obvious link
between legal systems and national economic
development (Laporta et al. 1998). In stagnant
economies, as exemplified in the current global
financial crisis, insolvent firms are a common
problem (Berg 2005), especially with small and
medium firms (Lussier and Halabi 2010). Con-
cretely, in Spain, the economic crisis is having a
negative impact on SMEs due to problems in
financing because of the lack of liquidity
and access to credit (Martin-López, García-
Gutiérrez-Fernández, and Lejarriega-Perez-
de-las-Vacas, 2010).
As in other European countries, Spain’s
bankruptcy regulations aim to preserve as
many firms as possible in order to reduce the
negative social, economic, and financial impact
of insolvency. However, due to the current
economic situation and law enforcement, offi-
cial bankruptcy statistics in Spain illustrate that
only one in ten Spanish companies with finan-
cial problems survives (National Statistics
Institute of Spain 2010). As shown in Figure 1,
the percentage of companies in financial dis-
tress has increased considerably.
 Figure 1
Trend Analysis of Bankrupt Companies with Effect of
Law 22/2003 in Spain
Source: National Statistics Institute of Spain (http://www.ine.es/en/welcome.shtml).
The bankruptcy procedure begins with the
declaration of bankruptcy from the judge.
Then, there is a period of company situation
analysis from the economic and financial point
of view. The law governing this procedure in
Spain is the Bankruptcy Act (Ley Concursal) LC
22/2003 of July 9th, which came into effect in
2004. This law is based on a single court pro-
ceeding that determines if a company is fit for
a going-concern agreement, simple reorganiza-
tion, or liquidation. Some national bankruptcy
laws provide a preventative mechanism for
negotiation between interested parties before
the beginning of the legal procedure. These
negotiations are designed to determine
whether the firm possesses a going-concern
value (Denning, Ferris, and Lawless 2001). In
Spain, as in Italy and Finland, this special pro-
cedure intended to avoid bankruptcy is called
“prebankruptcy” (preconcursal in Spanish),
which stops legal creditor requirements and
reorganizes the firm in four months. A firm is
eligible for “prebankruptcy” if it proves to be
solvent and is only temporarily unable to meet
its financial obligations. Consequently, a quick
reorganization agreement would save manag-
ers from entering the bankruptcy process and
its related consequences, including time delay,
costs, and the dissolution of business.
In summary, in Spain, it is possible for a
financially distressed firm to achieve reorgani-
zation in two ways. The first one, called
“prebankruptcy” (preconcursal), prevents the
bankruptcy process because firms voluntarily
CAMACHO-MIÑANO, SEGOVIA-VARGAS, AND PASCUAL-EZAMA
negotiate a reorganization agreement with
creditors prior to the bankruptcy procedure.
The second way requires firms and creditors to
enter the bankruptcy procedure. Once the
court decides that a company is solvent, firms
and creditors can negotiate terms of reorgani-
zation. Coincidentally, there is a newly drafted
bankruptcy law intended to change the 2003
Spanish Bankruptcy Law. This draft tries to
improve processes of corporate reorganization
to avoid bankruptcy, retaining as many busi-
nesses in the market as possible.
Previous Studies in
Bankruptcy Problems
The dynamic nature of economies as well
as the importance of SMEs to community eco-
nomic viability, owners and families, employ-
ees, customers, and suppliers suggest that
bankruptcy studies continues to be an impor-
tant research topic (Carter and Van Auken
2006). Core international studies about bank-
ruptcy have covered the following aspects: first,
factors that explain the bankruptcy situation
(Bhimani, Gulamhussen, and Lopes 2010 and
Keasey and McGuinness 1990, among others),
and other authors include these determinants
and look at their effects on the companies that
have already begun the bankruptcy process
(Bris, Welch, and Zhu 2006; Gilson 1997; and
Warner 1977, among others); second, studies
concerning the efficiency of various bankruptcy
laws in different countries (Couwenberg and de
Jong 2008; Easterbrook 1990; and Franks and
3
Torous 1989, among others); and finally,
studies analyzing financial distress by develop-
ing models to predict bankruptcy based on key
indicators (Altman 1968; Beaver 1966; and Fich
and Slezak 2008, among others), classifying
firms into groups based on the degree of bank-
ruptcy risk (Jones and Hensher 2004; Keasey
and McGuinness 1990), or comparing business
success versus failure prediction models
(Lussier 1995 and Lussier and Halabi 2010,
among others).
Moreover, there is also extensive literature
about failure prediction (Kumar and Ravi 2007)
because prediction models are important in
preventing insolvency and the subsequent con-
sequences like economic, financial, and social
losses. For example, these models are used for
monitoring the solvency of financial and other
institutions by regulators, for assessing loan
security, for evaluating going-concerns by audi-
tors, and for measuring portfolio risk ( Jones
and Hensher 2004). In every country, reorgani-
zation processes are “hot problems” because
there are conflicts of interests and asymmetric
information between creditors, owners, and
managers (Laitinen 2011). The agency theory
problems (Jensen and Meckling 1976) are
within bankruptcy procedures.
In general, bankruptcy prediction research is
diverse in its focus on methodological issues,
proposal models, and explicative forecasting
factors. A common practice in studying bank-
ruptcy prediction is to review the literature in
order to identify a large set of potential predic-
tive factors, including both financial and nonfi-
nancial variables, and then develop a set of
variables with prediction abilities (McKee and
Lensberg 2002) using a specific method. The
1960s mark the beginning of using accounting
and financial ratios as predictors of failure in an
attempt to classify a set of failure and nonfailure
firms (Beaver 1966). In addition, it has been
demonstrated that failing firms’ ratio measure-
ments exhibit significant differences when com-
pared to surviving entities (Altman 1968). A
large number of ratios have been proposed in
the literature in reference to profitability, liquid-
ity, and solvency ratios. Although ratios have
proved to be useful in earlier studies, they
continue to be frequently used in current studies
(Agarwal and Taffler 2007; Altman 2000) even
though accounting data of failed firms are
3
For a review of all these methodologies see Kumar and Ravi (2007).
4 JOURNAL OF SMALL BUSINESS MANAGEMENT
manipulated (García Lara, García Osma, and
Neophytou, 2009). However, market variables
provide significantly more information about
the firm’s probability of bankruptcy than any
accounting measures (Hillegeist et al. 2004), so
the notion of market efficiency is supported as
the most effective tool for forecasting bank-
ruptcy (Chava and Jarrow 2004; Chen, Chollete,
and Ray 2010; Xu and Zhan 2009). In some
instances, studies on distressed firms are
increased due to discrepancies in standard
accounting criteria (Beaver, McNichols, and
Rhie 2005). However, it is impossible to attain
this kind of market information for nonlisted
companies in our sample.
Another issue in failure prediction is the
methodology used in each study. There are
many kinds of methods, ranging from univariate
statistical to multivariate analytical methods,
used in earlier studies. Until the 1980s, the
multiple discriminant analysis method domi-
nated the field of business failure prediction,
and it remains the most accepted method used
on this topic (Balcaen and Ooghe 2006). Then,
the logit and probit analyses were introduced to
classify firms according to probability of bank-
ruptcy. The mixed logit model is a different
econometric model that applies to the case of
firm failures (Hensher and Jones 2007; Jones and
Hensher 2004). In order to overcome statistical
assumptions (dichotomy of data set, normality
of variables, equal dispersion matrices, multicol-
linearity, etc.), there are alternative3 methods
linked to the use of AI and data mining tech-
niques. The methods are the result of develop-
ment in information science and computers.
These scientific advances include different
neural network architectures, decision trees,
case-based reasoning, evolutionary approaches,
rough sets, soft computing, operational research
techniques, and other intelligent techniques
including support vector machine and fuzzy set
theory. The average overall predictive accuracy
(one year before actual bankruptcy) achieved by
these advanced models is over 85 percent (Aziz
and Dar 2006).
Nevertheless, the following are common
problems with these techniques: default
horizon bankruptcy prediction decreases over
time (Berg 2005) and, moreover, the classical
paradigm neglects the time dimension of failure
and the application focus in failure prediction
modeling (Balcaen and Ooghe 2006). Conse-
quently, all these techniques have pros and
cons. As seen in the economic crisis in 2007
and the subsequent worldwide recession,
economies need failure prediction accuracy
(Wu 2010). After more than 40 years of research
on this topic, there is still no generally accepted
model for bankruptcy prediction; yet with the
current worldwide economic crisis there is
growing necessity for an accepted model that
provides real solutions.
However, bankruptcy is a critical and
common event that detrimentally affects the
economy. When this critical—and often
inevitable—situation happens, it is important to
grasp the characteristics of bankrupt firms in
order to assess whether they will survive after
the legal procedure at the onset of bankruptcy.
Hence, the question remains: Which factors lead
to the survival of failing firms after the Spanish
bankruptcy process? The idea is to understand
the process outcome of reorganization at the
beginning of the legal process, and to propose a
prediction model for reorganization based on
Spanish bankruptcy law, avoiding the legal pro-
cedure and its negative consequences.
The benefits of knowing reorganized bank-
rupt firms’ features have to be taken into
account when considering the implications that
business failures have for the current market,
especially when bankruptcy is nearly inevitable
for many firms. According to the literature,
most bankruptcy prediction models are limited
(Nwogugu 2007). AI systems, such as RS,
should not only identify bankruptcy indicators
but also identify the important reorganization
factors. However, considering the methods dis-
cussed, the most common bankruptcy factors
are tested. In the next section the sample will
be presented, and then these hypotheses will
be contrasted with our sample.
Sample Description
In this paper we analyze all the companies
that are currently in the bankruptcy process in
the 12 commercial justice courts that operate in
4
SABI (Iberian Balance Sheet Analysis System) is a product of Bureau Van Dijk. For more information:
http://www.informa.es/en/financial-solutions/sabi.
5
To classify the companies’ sector the National Statistics Institute codification has been followed (CNAE-2009,
http://www.ine.es/jaxi/menu.do?L=1&type=pcaxis&path=%2Ft40%2Fclasrev%2F&file=inebase).
6
Rough set analysis was performed using RSES2, developed by the Institute of Mathematics, Warsaw, Poland.
http://logic.mimuw.edu.pl/~rses/
7
http://www.cs.waikato.ac.nz/ml/weka/
CAMACHO-MIÑANO, SEGOVIA-VARGAS, AND PASCUAL-EZAMA
Madrid. These companies represent 15.3
percent of the total number of bankrupt compa-
nies in Spain (National Statistics Institute of
Spain 2010). These data were extracted from the
Registrars of Spain (2010) webpage (https://
www.publicidadconcursal.es/) from May to July
2010. In total, there were 1,387 bankrupt com-
panies in Madrid during this period of time.
The main variables extracted are the date the
company began the bankruptcy process, the
type of process (compulsory or voluntary),
the court decision date, and the court decision.
This last variable considered is our decision
classification (liquidation or reorganization).
The data set is supplemented by the finan-
cial and accounting information obtained from
the SABI database.4 The variables considered
are the following: legal form (company by
shares or limited company), sector,5 legal foun-
dation day, number of shareholders and
amount of shareholdings, accounting informa-
tion from its balance sheets and income state-
ments, and the most relevant accounting and
financial ratios. A deeper analysis of the origi-
nal 23-variable set composed of accounting and
nonaccounting information (Table 1) resulted a
in new set containing only nine variables. The
nonaccounting variables, the legal form, and
the number of shareholders have been elimi-
nated because the firm size reveals the same
information. The cash ratio, return on assets
(ROA), and financial viability ratio were elimi-
nated for two reasons. First, the data contain
excessive ratio information, which is irrelevant
and correlated. In fact, the previous RS analysis
with 23 variables demonstrates that 15 attri-
butes are redundant. Second, the RS model
with 9 variables achieves the same results as
the sets containing 23 variables according to
the final selected reduct (see the fifth section).
Hence, the remaining nine ratios were selected
according to the ratios’ high frequency of
occurrence and the bankruptcy literature.
An assigned decision class (1 = reorganiza-
tion or 0 = liquidation) was entered into an
input file in RSES26 and WEKA7 (software used
5
 Table 1
Accounting and Nonaccounting Information
Explanatory Variables Definition Computer Code

Nonaccounting Variables
Sectora Spanish sector categories according to CNAE CNAE
Legal form Company by shares or limited company FJ
AGEa Number of years since the firm was founded AGE
NSa Number of shareholdings PARTICIP
ATa Firm’s size (total assets in base 10 logarithm) AT
NSh Number of shareholders ACCTAS
BTa Bankruptcy type (compulsory or voluntary) CONCURSO
BIPa Length of bankruptcy interim process (in days) FC
Accounting Variable
NI Net income RDO
Accounting Ratios
Current Ratio Current assets/current liability AC/PC
Cash Ratioa Cash/current liability TES/PC
Debt-to-Equity Total liability/equity DT/PN
Debt-to-Capital Ratio Total liability/(total liability + equity) DT/(DT + PN)
Bank Debt Ratio Financial debt/(financial debt + equity) DF/(DF + PN)
Short-Term Debt-to- Current liability/(total liability + equity) PC/(DT + PN)
Capital Ratio
NCA/TA Noncurrent assets/total assets AF/AT
CA/TA Current assets/total assets AC/AT
CR/CA Current receivables/current assets CC/AC
CS/CA Cash/current assets TES/AC
ROAa Return on assets; net income/total assets ROA
ROE Return on equity; net income/equity ROE
ROIC Return on invested capital; EBIT(1-t)/total assets ROIC
Financial Viability Financial expenses/EBITDA DF/EBITDA
Ratio*

a
Reselected after the first analysis of RS method.
CNAE, National Classification of Economic Activities; EBIT, earnings before interest and taxes;
EBITDA, earnings before interest, taxes, depreciation, and amortization.

to develop RS model and PART model, respec-
tively). Some sample filters were established
because firms that had not reached a court
decision also had to be eliminated. Once the
sample of bankrupt companies was defined,
data from five years prior to failure were
extracted from the SABI database.
The sample consisted of 235 bankrupt firms
in the Madrid court that had received the
judge’s decision (Table 2). It is worth consider-
ing that 61 percent of the companies are limited
companies, so many of them are really consid-
ered SMEs. Moreover, the “wholesale and retail
trade” sector (25.5 percent of the total sample),
the “construction” sector (23.8 percent of the
total sample), and the “manufacturing” sector
(21 percent of the total sample) are the most
representative in the sample.
Additionally, as Table 3 illustrates, the
majority of the bankrupt companies are not
start-up firms, but companies with a median
age of more than 18 years old. The total asset
mean is estimated around five million euros.
This information serves as a sign that most of
the companies are SMEs according to the Euro-
pean Commission Recommendation 2003/
361/EC (less than €10 million). It is essential to
point out these companies have a negative

6 JOURNAL OF SMALL BUSINESS MANAGEMENT

 Table 2
Sector and Legal Form Descriptive Statistics
Legal Form Total

Company by Limited
Shares Company

Sector
Accommodation and Food Service Activities 0 4 4
Administrative and Support Services 9 4 13
Construction 18 38 56
Education 0 1 1
Human Health and Social Work Activities 1 0 1
Information and Communication 7 8 15
Manufacturing 23 27 50
Other Service Activities 1 1 2
Professional, Scientific, and Technical Activities 8 14 22
Real Estate Activities 1 3 4
Transportation and Storage 1 6 7
Wholesale and Retail Trade 23 37 60
Total 92 143 235

Table 3 Focusing on the interim bankruptcy process, it

Main Firm Characteristics is essential for this study to observe that the
mean duration of the bankruptcy process is 454
days (almost one year and a quarter).
Characteristic Mean SDa
To obtain the decision rules, the data from
one year prior to bankruptcy were used, and
Age 18.06 10.289 then data from years 2, 3, 4, and 5 were
Total Assets 4,725,933.14 1.1145E7 employed to test those rules (Dimitras et al.
Sales 5,304,083.29 1.1168E7 1999). In each period, there were 196 liquida-
EBITDAb −288,858.74 1.2691E6 tions and 39 reorganizations; additionally, 26
Net Income −778,804.85 4,513,818 companies became going-concerns after the
BIP (days)c 453.89 289,689 process and 13 were liquidated despite the
ROAd −0.29 0.632 judge’s reorganization decision. This means
FV Ratioe −16.42 241,704 that for one-third of reorganizing companies,
Debt Ratio 2.07 5.32 the reorganization process ended in liquida-
Cash Ratio 0.14 0.33 tion. The lengthy duration of the process could
serve as an explanation for this rate of liquida-
a tion. The sample firms were followed from the
SD, standard deviation; bEBITDA, earnings
onset of financial distress to its resolution. The
before interest, taxes, depreciation, and amor-
process of sample selection is presented in
tization; cBIP, bankruptcy interim process;
d Figure 2.
ROA, return on assets; eFV, financial viability.
Methodology
AI is a new approach in analyzing financial
mean ROA , financial viability ratio, and earn- problems. These tools serve as a supplement to
ings before interest, taxes, depreciation and statistical methods, but in some cases can act as
amortization (EBITDA). Moreover, the high dif- a substitute for more traditional methods. Intel-
ference between net income and EBITDA ligent systems can be constructed in two ways
shows the negative financial and fiscal impact. (O’Leary 1998). The first is the so-called expert

CAMACHO-MIÑANO, SEGOVIA-VARGAS, AND PASCUAL-EZAMA 7

 Figure 2
Overview of Sample of Bankrupt Firms
Source: National Statistics Institute of Spain (2010) and http://www.registroconcursal.es.
systems approach. It consists of introducing
knowledge that human experts have accumu-
lated throughout their professional life into
a computer. The major limitation to this
approach is the process of gathering informa-
tion, because it must be done through a series
of interviews with experts. The second
approach is the machine learning approach.
Machine learning involves developing a com-
puter program capable of generating knowl-
edge through data analysis. This knowledge is
used to make inferences about new data. Arti-
ficial neural networks, rule induction algo-
rithms, and decision trees are techniques
associated with machine learning. Some of
these techniques are explanatory (rule induc-
tion and decision trees), whereas others are
characterized by their black box nature, such as
neural networks.
In the past, a large number of methods have
been proposed to deal with the bankruptcy
prediction problem. Most approaches used in
prediction are statistical techniques such as dis-
criminant or logit analysis (Dimitras, Zanakis,
and Zopounidis 1996) and, in many cases, the
attributes employed as explicative variables do
not satisfy statistical assumptions (Balcaen and
Ooghe 2006; Dimitras et al. 1999; McKee and
Lensberg 2002). In order to avoid the limita-
tions of statistical methods, an approach based
on RS and PART methodologies is proposed
that predicts which bankrupt firms will survive
and which will not. Both methods are effective
in analyzing real data and have many advan-
tages (Diaz, Sanchis, and Segovia 2009; Sanchis
et al. 2007). Moreover, these techniques are
explicative and guide decision rules with the
following term: “if conditions then decisions”—
meaning certain decisions (actions) should be
considered only when some conditions are
8 JOURNAL OF SMALL BUSINESS MANAGEMENT
satisfied. Next, the essentials of both methods
will be summarized.
The first methodology used is RS theory. It
was developed by Pawlak (1991) in the 1980s
as a mathematical tool to resolve the uncer-
tainties or vagueness inherent to a decision-
making process. Although nowadays, this
theory has been revisited (Greco, Matarazzo,
and Slowinski 1998, 2001), the classical
approach is still preferred. The philosophy
behind this approach is based on the assump-
tion that with every option considered we
can associate specific knowledge or data.
Knowledge in the decision-making process is
regarded as the ability to classify objects.
Objects described by the same data or knowl-
edge are indiscernible in view of such knowl-
edge. The indiscernibility relation leads to the
mathematical basis for the RS theory. Vague
information causes the indiscernibility of
objects depending on the data available and,
as a result, this prevents precisely assigning
an object to a set. Intuitively, an RS is a col-
lection of objects that, in general, cannot be
precisely categorized by the values of a set of
attributes.
A fundamental problem in the RS approach
is discovering dependencies between attributes
in an information table. These dependencies
enable reduction of a set of attributes by
removing those that are not essential (unnec-
essary) to characterize knowledge. This
problem will be referred to as knowledge
reduction or, in more general terms, as a
feature selection problem. The main concepts
related to this question are the core and the
reduct. A reduct is the minimal subset of attri-
butes that provides the same quality of classi-
fication as the set of all attributes. If the
information table has more than one reduct,
their intersection point is called the core; this
core is the collection of the most relevant attri-
butes in the table. Once the redundant vari-
ables have been eliminated, our model can be
developed and we can obtain the decision
rules. Because feature selection in bankruptcy
prediction is a complicated process and analyz-
ing a large amount of firms’ information has
costs and risks (Tsai 2009), those rules could be
useful to judges, managers, judicial officers,
shareholders, banks, and creditors.
The second methodology used is the PART
algorithm (Frank and Witten 1998). It is a
classifier that generates production rules by
incorporating a modified form of the J48 deci-
sion tree algorithm (the data mining package
WEKA’s implementation of the C4.5 decision
tree learner) and eliminating some of the
paths found in an initial decision tree struc-
ture. In fact, PART is a rule-learning algorithm
based on partial decision trees (Witten and
Frank 2005). More flexibility and speed is
achieved by using these combined methodolo-
gies. However, its main advantage over other
schemes is not performance but simplicity.
PART joins both strategies by following the
key idea of building a partial decision tree (an
ordinary decision tree that contains branches
to undefined subtrees) instead of a fully
explored one. Once this subtree has been
found, tree-building ceases, and a single rule
can be read off. PART aims at the most
general rule by choosing the “leaf” that rep-
resents the greatest number of situations.
Empirical Findings
Reorganization prediction is to assign firms
(objects) to a decision group (liquidation or
reorganization) based on a set of variables
(attributes). Our objective is to extract informa-
tion patterns and notable regularities (rules)
from the sample to get a reorganization model
with our data.
RS Model
In the RS model, the continuous variables
are recorded into qualitative terms. This
recoding divides the original domain into sub-
intervals. This is not imposed by the RS theory,
but it is very useful to draw general conclusions
from the variables in terms of dependencies,
reducts, and decision rules (Dimitras et al.
1999). It is best to avoid subjective input, so
experts recode the variables according to their
experience and standards of financial analysis.
CAMACHO-MIÑANO, SEGOVIA-VARGAS, AND PASCUAL-EZAMA
Accordingly, the subintervals are based on the
percentiles (10th to 90th) representing the
actual variable values (year 1) for the whole
sample. As we do not have prior knowledge
about other partitions that make more eco-
nomic sense, percentiles are frequently used in
scientific research to divide a domain into sub-
intervals (Laitinen 1992; McKee 2000). To sum
up the model, the continuous variables repre-
sent values 1 to 10 (1 for the 10th percentile
and so on, so lower codes are assigned to the
first percentile and so on) based on their per-
centiles as determined by the recoding process.
One of the first results obtained is that none
of the attributes are indispensable for the
approximation of the two decision classes (so
the core was empty). We obtained 17 reducts
from the table that contain 4–5 attributes. This
result showed that at least four attributes out of
nine were redundant, so they could be elimi-
nated. Therefore, by reducing redundancies
this model proves to be an efficient feature
selection method. The reduct consisting of
sector, cash ratio, ROA, and firm size was
selected, taking into account the following two
premises: the reduct should have the least
number of attributes possible while still having
the most significant attributes for the compa-
nies’ evaluation. These results are broadly in
line with those obtained by Bhimani,
Gulamhussen, and Lopes (2010), Chava and
Jarrow (2004) and McKee and Lensberg (2002).
The current crisis does not have the same
impact on all sectors. In fact, the “wholesale
and retail trade” and “construction” sectors rep-
resent the majority of bankrupt firms in our
sample due to their dependency on exports and
the financial chasm in the world (Alonso and
Furio 2010).
Consequently, the decision rules have been
obtained from the reduced table with only four
variables. To interpret the rules, only the stron-
gest ones for each decision class have been
selected; thus ,46 rules have been considered
(Table 4).
Before the interpretation of rules, the model
requires validation. The rules were tested on
data from 2, 3, 4 and 5 years before the actual
ratio values (year 1) (Dimitras et al. 1999). The
percentage of correctly classified firms is
shown in Table 5.
When a model is developed and tested with
the same sample firm, but using data from
different years, the results obtained could be
conditioned. So in order to avoid conditioning,
9
 Table 4
Strongest Rules for Each Decision Class
Rule CNAE TES/PC ROA AT Decision Strength

1 4 0 23
2 F 9 0 9
3 C 1 0 9
4 1 1 0 8
5 C 1 0 8
6 F 10 0 8
7 F 1 0 7
8 1 1 0 7
9 F 8 0 7
10 5 5 0 7
11 F 7 0 7
12 G 7 0 6
13 5 5 0 6
14 3 5 0 6
15 M 3 0 6
16 F 9 0 6
17 F 5 0 6
18 9 10 0 6
19 F 2 0 6
20 M 3 0 5
21 M 2 0 5
22 1 1 0 5
23 F 3 0 5
24 3 5 0 5
25 F 5 0 5
26 F 6 0 5
27 5 5 0 5
28 3 2 0 5
29 G 5 0 5
30 G 6 0 5
31 9 8 1 3
32 C 10 1 3

Table 5
Classification Accuracies (percent)
Year 1 Year 2 Year 3 Year 4 Year 5

Weighted Average 100 81.3 82.1 75.6 73.8

10 JOURNAL OF SMALL BUSINESS MANAGEMENT

 Table 6
Cross-validation Procedure
Result
Year 1
Weighted Average 76 percent
10-fold cross-validation8 tests have been used
to evaluate the quality of the learned model
(rules) using data from year 1. The year 1
results are presented in Table 6.
Therefore, the results obtained allowed us to
interpret the rules. Taking into account Table 4,
the rules would be read in the following way:
• If sector (CNAE) = F (construction) and
performance (ROA) = 9 (out of 10), then 0
(liquidation).
• If sector (CNAE) = C (manufacturing)
and size (AT) = 10 (out of 10), then 1
(reorganization).
• If . . . and so on.
Then, these rules were analyzed by using the
number of objects that satisfy the conditional
part of the rule (the strength of the rule) to
draw one of the following conclusions:
(1) The majority of the rules refer to class 0
(liquidation). These results confirm that it
is easier to develop a model for this class,
and the class 1 model will be developed
by exclusion.
(2) Most of the rules (62.5 percent) relate
sector to insolvency situations. This means
that the sector affects the survival of com-
panies in financial difficulties. In fact, this
is reflected in the bankruptcy statistics for
2009 in Spain. The construction (F) and
retail (G) sectors endure the greatest
impact.
(3) The variables total assets, ROA, and
liquidity remain in the low and middle
percentiles for liquidated companies. By
contrast, they appear to have high percen-
tile values (seventh or above) if they are
associated with the construction sector
(F, four rules) or the commercial sector
(G, one rule). The following conclusion
can be drawn from this finding: construc-
tion companies will be liquidated when
they come into the bankruptcy process,
regardless of their economic and financial
situation. Extensive research corroborates
this conclusion (Chava and Jarrow 2004;
Laitinen 2011).
(4) There are only two rules related to reor-
ganization. These two rules refer to com-
panies in the manufacturing sector with
high values for the size variable (rule 32)
and to very high values for the cash ratio
and ROA (rule 31). This means that large
companies (measured by asset value)
entering the bankruptcy process with high
liquidity and ROA are more likely to
remain in operation in the future
(Shumway 2001).
PART Results
Following the same philosophy as RS, the
PART model was developed using continuous
variables. Table 7 shows the decision list.
The decision lists were validated before pro-
ceeding. The lists were analyzed using a cross-
validation procedure. obtaining a 79.15 percent
share of correctly classified firms. Therefore,
the results obtained are also quite satisfactory
in terms of classification, and they allow us
to interpret the rules to draw the following
conclusions:
(1) The results show first the impact of
belonging to a group of companies
(PARTICIP variable). It is shown that not
belonging to a group (PARTICIP = 0) is
associated, in a majority of cases, with
liquidation (0). Interestingly, this result is
consistent with the bankruptcy probability
literature (Carter and Van Auken 2006).

8
Cross-validation comprises several training and testing runs. The data set is first split into several, possibly
equal in size, disjointed parts. Then, one of the parts is taken as a training sample and the remainder (sum
of all other parts) becomes the test sample. The classifier is constructed by means of the training sample and
its performance is checked against the test sample. These steps are repeated as many times as there are data
parts, so that each of the parts is used as training set once. The final result of the cross-validation procedure
is the average of scores from subsequent steps.

CAMACHO-MIÑANO, SEGOVIA-VARGAS, AND PASCUAL-EZAMA 11

 Table 7
PART List
Rule PARTICIP CNAE Age AT Decision Strength

1 0 F 0 (55/4)
2 0 G 0 (54/9)
3 0 M 0 (18/1)
4 0 J 0 (13/2)
5 0 N >9 0 (9)
6 0 C ≤6.664 0 (43/5)
7 C 1 (7/1)
8 1 0 (11/3)
9 0 H 0 (6)
10 0 I 0 (4/1)
11 0 L ≤12 1 (2)
12 0 0 (8/3)
13 2 1 (2)

(2) The most important variable, as in the
previous method, is again the sector. The
strongest rules (1, 2, 3) indicate that
the sectors F (construction), G (trade), and,
to a lesser extent, M (scientific and techni-
cal activities) are associated with class 0
(liquidation). Hence, the same conclusions
were achieved using the RS algorithm.
(3) Small firms in the C sector (manufacturing)
are associated with class 0 because of low
asset values, but in any other case, this
sector would be associated with the reor-
ganization class. So the PART model cor-
roborates the conclusions drawn by the RS
methodology.
Conclusions
The objective of this paper is to identify the
characteristics of insolvent firms in order to
achieve a preventive diagnosis for reorganiza-
tion after the bankruptcy procedure, avoiding
the complex legal bankruptcy process for finan-
cially distressed companies. To obtain this aim,
two artificial intelligence methods are used in a
sample of bankrupt Spanish firms. The conclu-
sions of this paper would be useful for all the
stakeholders in companies’ financial distress
problems or even for still-healthy firms.
Bankruptcy is a timely and devastating eco-
nomic problem due to the current global finan-
cial crisis, and its consequences have significant
effects on businesses, economies, and societies.
In order to minimize these effects on the
Spanish economy, the government has tried to
incentivize a preventive phase of bankruptcy
called “prebankruptcy” (preconcursal) to avoid
bankruptcy consequences (costs and delays). A
new approach to predict reorganization before
the beginning of the legal procedure is pre-
sented using RS and PART methods. Our results
are self-enhancing because we think we have
achieved our research objective, that is, to get a
minimum set of variables for SMEs in order to
identify the reorganization key. Moreover, the
models obtained are fit because the classifica-
tion percentages are better than other studies
about failure prediction (Lussier and Halabi
2010).
Therefore, the decision rules obtained with
these methods are useful for judges, lawyers,
creditors, shareholders, banks, and auditors to
make decisions involving the legal insolvency
process. Moreover, financial support for reor-
ganizing firms could be more efficient if public
policymakers and others use the model pro-
posed to assess a firm’s potential for continuity,
and society can benefit via government aid,
loans, and so forth focusing on the companies
that have more chances of survival.
In practical terms, the decision rules gener-
ated with the sample could be used to preselect
companies quickly and inexpensively, thereby
efficiently managing the financial user’s time.
These rules could be used as a “warning
system” for decision-makers, enabling them to
check and monitor bankrupt firms before and

12 JOURNAL OF SMALL BUSINESS MANAGEMENT

after the legal insolvency process. In any case,
the models are not a substitute for expert
knowledge, but they can serve as an auxiliary
tool to complement the final decision.
The RS and PART methodologies used in our
sample show that sector, size, number of
shareholdings, ROA, and liquidity could
explain the bankruptcy process outcome and
also predict the process for still-healthy firms.
For example, both those algorithms show that
there are sectors in Spain, like construction
and, to a lesser extent, trade, whose peculiari-
ties and the current crisis make their survival
impossible, even though the financial data may
show a potential for reorganization. This is an
important conclusion for our study: analyzing a
set of five variables from any company, we can
monitor it in order to predict its survival in the
market. The ROA and cash ratio should have
high values, as the models obtained show that
the combination of low profitability with liquid-
ity problems will lead to a real financial col-
lapse. Moreover, the participation of the firm in
a group could “cushion” serious financial prob-
lems because belonging to a group of firm acts
as a defense against bankruptcy, as the partner
companies can assist the company in financial
distress.
Finally, it is our intention in the near future
to use different methods to validate the results,
to enlarge the sample, and to set up a cross-
national study. This paper is the origin of a
software development based on soft computing
techniques to make the decisions taken by the
stakeholders in the bankruptcy procedures
easier.
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