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JSBED 17,1

The bias of unhealthy SMEs in bankruptcy prediction models

J. Samuel Baixauli and Antonina Modica-Milo
Department of Management and Finance, University of Murcia, Espinardo, Spain
Abstract
Purpose This paper aims to construct a nancial health indicator to dene the degree of nancial health in order to decontaminate the estimation sample and to make predictions that are not biased by unhealthy rms. Design/methodology/approach The binomial logit model is used to examine the likelihood that a rm will go bankrupt. In order to evaluate the accuracy of the estimated models, measures proposed by the Basel Committee on Banking Supervision are applied: cumulative accuracy prole (CAP) and the receiver operating characteristics (ROC). Findings The proposed nancial health indicator permits the heterogeneity of the rms to be reduced as well as identifying a strong rm sample to estimate the bankruptcy probability accurately. Originality/value A drawback of all bankruptcy prediction models comes from the fact that bankruptcy is an example of a homogeneous observable qualitative response while non-bankruptcy would be expected to be represented by a healthy rm. However, the non-bankruptcy rms are heterogeneous and their actual probabilities of bankruptcy are non-observable. The article adds to the previous literature on SMEs bankruptcy prediction by using a nancial health indicator to construct the estimation sample and to make accurate bankruptcy predictions. Keywords Bankruptcy, Business failures, Mathematical modelling Paper type Research paper

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Journal of Small Business and Enterprise Development Vol. 17 No. 1, 2010 pp. 60-77 q Emerald Group Publishing Limited 1462-6004 DOI 10.1108/14626001011019134

Introduction The small and medium-sized enterprise (SME) sector is often viewed as the incubator of employment, innovation and growth (Craig et al., 2003). The reports by the observatory of European SMEs use statistics on the number of enterprises, total employment and production by rm size to provide an overview of the current situation in the SME sector in Europe. Regardless of how they are measured, not only are most enterprises in Europe small, but they also account for a signicant amount of European work experience and economic activity. For instance, in 2003 there were more than 19 million enterprises in Europe, providing jobs for almost 140 million people. In contrast, there were only about 40,000 large enterprises in existence, which accounted for only 0.2 per cent of all enterprises. So, the vast majority of enterprises in Europe are SMEs. Zingales (2000) points out that, empirically, the attention paid to large companies has lead researchers to ignore the rest of the young and small rms, which do not have access to public markets. SMEs are nancially more constrained than large rms and are less likely to have access to the capital market. Nowadays, due to the lack of capital market data, the bank sector uses techniques based on models where nancial ratios are combined and
The authors thank Fundacion Cajamurcia and the Spanish Government (Project ECO 2008-02846) for nancial support.

weighted to produce a probability of bankruptcy in order to estimate the bankruptcy probability. Bankruptcy is disruptive and costly to owners, investors and communities. Despite the existence of many contributions, the bankruptcy prediction continues to be an important issue. As Altman and Saunders (1998) point out, an increase in the number of bankruptcies, more competitive margins on loans, and a trend towards disintermediation by the highest quality and largest borrowers have led to the development of new and more sophisticated credit-scoring and early-warning systems. Altman and Saunders (1998) review new models of credit risk measurement, for example the KMV model, models based on the term structure of yield spreads, mortality-default rate models, and neural network models. These models are based on capital market data and quoted rms. However, the difculty of SMEs in accessing the capital market restricts the use of such models. In Europe only a very small percentage of SMEs are quoted rms. Many bankruptcy prediction models thatcombine nancial ratios have been proposed in the literature. Of these, the models of Beaver (1968), Altman (1968) and Altman et al. (1977) are worthy of note. A drawback of all bankruptcy prediction models comes from the fact that bankruptcy is an example of a homogenous observable qualitative response, while non-bankruptcy would be expected to be represented by a healthy rm. However, non-bankruptcy rms are heterogeneous and their degree of nancial health is non-observable. Our article adds to the previous literature on SMEs bankruptcy prediction by identifying the characteristics of a healthy rm and by evaluating the effects of using or not using these characteristics in the sample design on the accuracy of the bankruptcy prediction models. In the evaluation process, statistical methodologies recommended by the Basel Committee on Banking Supervision are used. Our proposal is compared with the traditional methodology based on unbalanced samples and on matching by size and industry. The structure of the paper is as follows: the next section discusses bankruptcy prediction models and the denition of healthy rms in order to exclude rms with high probability of bankruptcy. The subsequent section outlines methods used to analyse the data. The next section covers the data collection and discusses the ndings of the analysis. The nal section concludes with a discussion of the ndings. Bankruptcy prediction and the bias of non-bankruptcy rms According to Berryman (1983) there are different denitions of failure: . earning a rate of return signicantly and continually below prevailing rates on similar investments; . ceased operations; or . termination for any reason. When the use of bankruptcy prediction models is the main issue, failure is dened as only those rms that are declared bankrupt, and non-bankrupt rms are any other rms. Such denitions mean that rms with a much more general denition of nancial distress or failure are also included among non-bankrupt rms. They have high bankruptcy probability even though they cannot be classied as bankrupt rms. For example, a failure denition could include discontinued ownership (ownership

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changes), business discontinuance (the business ceases to exist) or failing to make a go of it. Often, rms that satisfy the wide denition of failure are not bad rms to invest in. In this sense, a change in ownership may not imply failure because the business may continue under a different owner. Watson and Everett (1999) believe that discontinuance may signal actual failure because business resources may have been reallocated to more protable areas. Headd (2003) makes a compelling argument that discontinuance may not be associated with failure. Many nancially strong rms may cease to continue because of an existing strategy. The meaning of discontinuance is too wide and includes rms that sell because they are successful and are offered a good price and rms that are taken over. In this sense, Cochran (1986) points out that businesses may be discontinued because of extraneous factors such as retirement or illness, because alternative opportunities present themselves, or under some denitions of discontinuance, even because the business is sold at a prot. As Watson and Everett (1996) point out, the broader the denition of failure, the higher the failure rate for small rms. In order to show that bankruptcy probabilities are unobservable variables, Carter and Van Auken (2006) dene failure as only those rms that declare bankruptcy. All this evidence gives risk managers and researchers a range of rms with different degrees of failure and different bankruptcy probability. In fact, Watson and Everett (1999) test the relation of the probability of failure with the years of life of a business and with the barriers to entry in an industry sector by considering three different denitions of failure (bankruptcy, discontinuance of ownership and failing to make a go of it). The sample design employed by many research studies has been to match a set of bankrupt rms with the same number of non-bankrupt rms, often controlling for size and industry (see Altman, 1968; Theodossiou et al., 1996; Carter and Van Auken, 2006, among others). Matching unhealthy non-bankrupt rms with bankrupt rms in order to estimate the parameters of a bankruptcy prediction model produces a bias in the estimated parameters and a reduction in the ability to predict bankruptcy accurately. As a consequence, it is necessary to make a previous selection in order to include non-bankrupt rms with good nancial health in a model. As the degree of nancial health is unobservable, in this article an indicator of nancial strength is constructed. If this indicator is positively correlated with the nancial health, then to match non-bankruptcy rms characterised by having high values of the nancial health indicator with bankrupt rms should allow us to estimate bankruptcy prediction models with less prediction error than the models that match non-bankrupt rms characterised by low values of the nancial health indicator with bankrupt rms. Statistical records are satisfactory for listing bankruptcies or discontinuances, but they cannot cope with identifying the severity of failures. The denition of non-bankruptcy should be devoid of unsuccessful rms with a low degree of nancial health. The economic denitions of failure take protability as a common denominator. In this line, Fredland and Morris (1976) state that any rm earning a rate of return on investment that is less than the rms opportunity cost is a failure. Following the denition of Altman (1968), a non-bankrupt rm is a failure if it is earning a rate of return on invested capital which is signicantly and continually below prevailing rates on similar investments. Causes of failure can be classied as endogenous (internal to

the rm) and exogenous (external to the rm). Exogenous causes, such as exchange rates or high interest rates, ascribe their failure to problems in operational management and endogenous causes are widely related to poor operational management, high costs of production, poor marketing policy and poor personal management (Hall and Young, 1991). We select four measures of protability to construct our nancial health indicator: . the return on assets; . capital turnover; . return on equity; and . net worth variation. As the prot measures may be managed gures subject to deliberate manipulations, we add the auditing opinion: . Return on assets (FR1), measured by earnings before interest and taxes over total assets. This variable measures the economic efciency of a rm, i.e. its capacity to generate prots independently of its nancial structure, debt cost, taxes or the protability required by the owners. . Capital-turnover ratio (FR2), measured by the sales over total assets. This ratio is a standard nancial ratio illustrating the ability of the rms assets to generate sales. It is a measure of managements capability in dealing with competitive conditions. . Return on equity (FR3), measured by the net income to net worth. This variable measures the nancial protability, which depends on the economic protability as well as on the nancial structure, debt cost and the protability required by the owners. A positive return on equity reects the opportunity for retaining earnings. . Change of net worth (FR4), measured by the net worth annual percentage change. This variable represents the solvency increase or decrease. . Auditing opinion (d5): this measures the quality of the nancial statements. Edmister (1972) tested the same technique as Altman (1968) for small business with some success but warned that three consecutive nancial statements of good quality must be available for analysis of a small rm. The expression of the nancial health indicator is given by: FS
4 X j1

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63

I FRj $ P 5 d5 ;

where FR is the nancial ratio, P5 is the fth percentile, d5 is a dummy variable which takes the value 1 if the auditing opinion is favourable and 0 otherwise, and I(.) is the indicator function, which takes the value 1 if FR is higher than or equal to P5 and 0 otherwise. If this is a good indicator of the bankruptcy probability of healthy rms, it will allow us to form decontaminated samples and the prediction models will give much more accurate bankruptcy predictions. If a rm shows a value of the nancial health

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indicator below the fth percentile, it reveals that it has an abnormal reduced indicator value, which means that it is nancially a weak rm. It is expected that, if FS is a good proxy of nancial health, using rms with an FS value equal to 5 (healthy rms) should allow us to predict bankruptcy more accurately than using rms with FS equal to 0 (unhealthy rms). The indicator FS is evaluated on several bankruptcy prediction models to avoid results in which it could be inuenced by the selected model. The models we use are those of Beaver (1966), Altman (1968), and Altman et al. (1977). These models are the most widely cited bankruptcy prediction models in the credit risk literature. Also, Garca et al. (1997) presented a bankruptcy prediction model that represents the reference in the Spanish market. All the models above examine multivariate ratios in large and small rms. They are displayed in equations (2)-(5): P ij f CASH i ; NIN i ; LEV i ; WC i ; LIQi ; NCRE i Beaver; 1966; P ij f WC i ; CP i ; ROAi ; CAP i ; ACT i Altman; 1968; P ij f ROAi ; S ROAi ; DS i ; CP i ; LIQi ; CAP i ; SIZE i Altman et al:; 1977; P ij f QLIQi ; ATDi ; INT i ; AMOi ; EARi Garcia et al:; 1997: 2 3 4 5

The ratios employed are: . Beaver (1966) CASH, cash ow to total debt; NIN, net income to total assets; LEV, total debt to total assets; WC, working capital over total assets; LIQ, current assets to current debt; NCRE, no-credit interval measured as quick assets minus current liabilities to operating expenses minus depreciation, depletion, and amortisation. . Altman (1968) WC, working capital over total assets; CP, retained earnings over total assets; ROA, earnings before interest and taxes over total assets; CAP, for application purposes a ve-year average of the total market value equity over total capital has been substituted by book value equity over total capital; ACT, sales over total assets. . Altman et al. (1977) ROA, earnings before interest and taxes over total assets; SROA, standard error of estimating of ROA; DS, earnings before interest and taxes over total interest payments; CP, retained earnings over total assets; LIQ, current assets to current debt; CAP, for application purposes a ve-year average of the total market value equity over total capital has been substituted by book value equity over total capital; SIZE, logarithmic transformation of total asset. . Garca et al. (1997) QLIQ, quick assets over current libialities; ATD, total asset to total debt; INT, total interest payments to sales; AMO, annual amortization to amortizable assets; EAR, earnings before taxes over total debt. Methodology We use the binomial logit model to examine the likelihood that a rm will go bankrupt. Logit analysis uses a set of nancial variables to predict bankruptcy probability, assuming that bankruptcy probability is logistically distributed, i.e. the cumulative

bankruptcy probability takes a logistic functional form and is, by denition, constrained to fall between 0 and 1. In the prediction evaluation process we distinguish between the in-sample validation and the out-of-sample validation, in the estimation year, when applying the model to the non-used sample in the estimation process, as well as in the next two years to the whole population of rms. Under non-normality, we choose the logistic regression model with maximum likelihood estimators. The regression model is specied as follows: P ij 1 ; 1 e 2b0 X 6

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65

where Pij is the probability that rm i is bankrupt, X is a vector of measured characteristics for rm i, and b is the unknown parameter vector. The estimates of the parameters of this model yield the bankruptcy probabilities for a given rm. The vector of measured characteristics used contains the list of empirical variables described in equations (2)-(5). The nancial ratios are calculated at the end of the year prior to the bankrupt year, except the standard error of estimating of ROA of Altman et al. (1977), which is computed over seven years. If the model, as represented by the likelihood ratio statistic, indicates that the model ts the data signicantly, we then move on to interpret parameter estimates. We also compute the McFadden R 2. In order to classify the rms belonging to the sample under the estimated bankruptcy probabilities, a cut-off must be xed which allows the sample to be dichotomise and the prediction errors to be determined. The type I error is dened as those non-bankrupt rms which have already been classied as bankrupt and the type II error is dened as those bankrupt rms which have been classied as non-bankrupt. The total error is obtained by weighting type I and type II errors. Since type I and type II errors are conditioned by the selected cut-off, we apply two evaluation measures proposed by the Basel Committee on Banking Supervision (BCBS), which are constructed for all possible cuts-off: (1) the cumulative accuracy prole (CAP); and (2) the receiver operating characteristics (ROC). Given a variety of rating methodologies, the question is which of these methodologies deliver acceptable discriminatory power between bankrupt and non-bankrupt rms. The Basel Committee on Banking Supervision (2005) has published a working paper summarising statistical methodologies for assessing discriminatory power. Accuracy ratio of cumulative accuracy prole To obtain the cumulative accuracy prole (CAP) curve, all rms are rst ordered by their respective scores, from riskiest to safest, i.e. from the rm with the highest score to the rm with the lowest score. For a given fraction x of the total number of rms, the CAP curve is constructed by calculating the percentage d(x) of the bankruptcy rms whose rating scores are equal to, or higher than, the maximum score of fraction x. This is done for x ranging from 0 per cent to 100 per cent. Figure 1 illustrates the CAP curves. A real credit model lies somewhere in between the two extremes of a perfect rating credit model and a random model. In a perfect rating model, the CAP increases linearly to 1 then remains constant, since a perfect rating model will assign the highest scores

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Figure 1. Cumulative accuracy prole curves

to bankrupt rms. In a random model, the fraction x of all rms with the highest rating scores will contain x per cent of all bankrupt rms. The accuracy ratio (AR) is dened as the ratio of the area between the real credit model and the random model ar, and the area between the perfect rating model and the random model, ap. The closer the AR is to 1, the better the rating model: ARCAP ar : ap 7

Accuracy ratio of receiver operating characteristic The decision as to which rms will not go bankrupt during the next period and which rms will is made by introducing a cut-off value C, as in Figure 2. Thus, a rm with a bankruptcy probability lower than C is classied as a non-bankrupt rm and a rm with a bankruptcy probability higher than C is classied as a bankrupt rm. Consequently, a hit rate HR(C) is dened as the fraction of bankrupt rms that are classied correctly for a given cut-off value C:

Figure 2. Distribution of bankruptcy probability for bankrupt and non-bankrupt rms

HRC

H C : NB

The bias of unhealthy SMEs

In equation (8), H(C) is the number of bankruptcies predicted correctly with the cut-off value C, and NB is the total number of bankruptcies in the sample. The false alarm rate FAR(C) is dened as: FARC FC ; N NB

67
9

where F(C) is the number of non-bankrupt rms that were classied incorrectly as bankrupt by using the cut-off C and NNB is the total number of non-bankruptcy rms. In Figure 2, HR(C) is the area to the right of the cut-off value C under the probability distribution of the bankrupt rms, while FAR(C) is the area to the right of C under the probability distribution of the non-bankrupt rms. The receiver operating characteristic (ROC) curve is a plot of HR(C) versus FAR(C), illustrated in Figure 3. To construct the ROC curve, HR(C) and FAR(C) are computed for different possible cut-off values in the range 0 to 1. Like the CAP curve, the larger the area under the ROC curve, the better the model. The area is called AUROC. In a random model with no discriminative power, AUROC is equal to 0.5. In a perfect model AUROC is equal to 1. Engelmann et al. (2003) showed a measure between 0 to 1 as an accuracy ratio for ROC, which is computed using the following expression: Z 1 HRFARdFAR 2 1: 10 ARROC 2 AUROC 2 1 2
0

Data and empirical results The period is divided into two subperiods to estimate the bankruptcy prediction models: (1) from January 1994 to December 2000 we compute the nancial variables; and (2) from January 2001 to December 2004 we estimate the models and evaluate their predictive capacity.

Figure 3. Receiver operating characteristic curves

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Firms belonging to a nancial sector were excluded from the sample. Our sample consists of rms which satisfy the European Commission denition of SMEs and which have accounting data from January of 1994 to December 2004. Following the European Commission denition, we consider SMEs as: . companies with fewer than 250 employees; . sales below e40 million; and . total assets under e27 million. We use a database that includes nancial information of more than 190,000 Spanish rms. This database is called SABI, and is managed by Informa SA. In the database, 76 bankrupt rms were found during the period January 2001 to December 2004. From the 76 bankrupt rms, 27 rms were deleted due to lack of continuous information in at least one of the ve years previous to the bankruptcy event, and one rm was deleted because it was not considered a SME. Therefore, the nal sample is formed by 48 bankrupt rms. This gives a total sample of 2,211 rms in 2000, where 2,194 are non-bankrupt rms and 17 are bankrupt rms. In 2001, the sample consists of 2,130 rms, where 2,113 are non-bankrupt rms and 17 are bankrupt rms. In 2002 there are 2,299 rms, consisting of 2,292 non-bankrupt rms and seven bankrupt rms. In 2003 there are a total of 2,310 rms, of which 2,303 are non-bankrupt rms and seven are bankrupt rms. We equate the number of non-bankrupt rms selected from each year to the number of bankrupt rms for such year. We select three samples of non-bankrupt rms: (1) the high nancial health sample (strong rms); (2) the low nancial health sample (weak rms); and (3) the classical sample (control rms). We also use the whole sample to estimate the model (total rms). In the high nancial health sample, the non-bankrupt rms are selected from the rms that obtain an indicator value equal to 5. In the low nancial health sample, the non-bankrupt rms are selected from those rms that obtained an indicator value equal to 0. In the classical sample, the non-bankrupt rms are selected from the rms that belong to the same sector as the bankrupt rms. Using each of these four samples, in 2001 we estimate the bankruptcy prediction models of Beaver (1966), Altman (1968), Altman et al. (1977) and Garca et al. (1997). Then, given the estimated bankruptcy probabilities, we measure the in-sample prediction capacity and the out-of-sample predictive ability of such models. The in-sample prediction capacity is measured using the rms that were not employed in the estimation process in 2001, and the out-sample prediction capacity is computed using the whole rm population in the two next years. We repeat the analyses, re-estimating the models in 2002. We do not repeat the estimation in 2003 and 2004 because of the small size of the bankrupt sample. In the estimation process, we estimate several logit models. The estimation results of the Beaver (1966, 1968) model are reported in Table I. These results show that the samples formed by weak rms and total rms have the lowest McFaddens R 2 in 2001, while the control rm sample has a quite good value in 2001, taking into account this type of data, but a very small one in 2002. The signicance of 2 2 log L the statistics

Strong rms

2001 Weak rms Control rms Total rms Strong rms Total rms

Year Weak rms Control rms

Constant

CASH

NIN

LEV

WC

LIQ

NCRE

22 log L 0.000 0.4797 85.29 17.65 11.76 0.9298 0.7625 79.41 23.53 17.65 0.8728 0.7586 91.18 11.76 5.88 0.9140 0.7165 99.41 0.00 76.47 0.7879 0.3079 88.24 11.76 11.76 0.9524 0.7901 0.0117 0.3484 0.0000 0.6751 0.0000 0.2943 0.0005 0.5103

215.32 (11.40) 17.47 (25.06) 271.34 (51.75) 15.92 (12.26) 2 1.32 (10.78) 3.14 (4.65) 2.66 (4.13) 22.61 26.87 (9.49) 20.43 (20.06) 26.96 (27.91) 12.18 (7.87) 8.29 (14.76) 22.44 (7.75) 22.04 (5.26) 24.05 0.1565 0.1977 64.71 41.18 29.41 0.7981 0.5733 0.0257 0.3051 76.47 23.53 23.53 0.8506 0.8461 22.42 (3.30) 25.58 (9.80) 9.01 (13.08) 5.99 (3.72) 5.61 (4.67) 22.25 (1.90) 21.53 (2.27) 9.32

211.34 * (5.56) 19.34 (12.16) 6.38 (9.70) 11.78 * (5.85) 24.49 (4.61) 1.65 (1.64) 0.82 (1.22) 16.42 2 17.50 (17.10) 15.65 (41.06) 2142.07 * (80.05) 20.19 (19.00) 2 0.61 (12.66) 4.11 (4.39) 0.82 (5.23) 31.82

210.98 * (2.48) 27.47 (7.49) 1.63 (9.23) 6.31 * (2.68) 23.62 (2.72) 1.68 * (0.87) 20.38 (0.90) 58.69

222.13 * (12.94) 222.39 (18.19) 20.98 (22.68) 21.55 (5.61) 230.72 (20.45) 23.56 (13.88) 23.24 (3.76) 14.38

2 10.81 * (3.25) 2 3.63 (7.64) 2 15.64 (10.74) 8.49 * (2.71) 1.74 (4.18) 2 0.30 (2.21) 2 0.28 (1.07) 65.75 0.0000 0.3319 99.30 0.05 82.35 0.7829 0.3199

x 2 p-value McFadden R 2

Accuracy in-sample Percentage classied Type I error (per cent) Type II error (per cent) ARCAP ARROC

Notes: The sample is composed of 17 bankrupt rms. The dependent variable takes the value one for the 17 bankrupt rms and zero for the nonbankrupt rms. Standard errors are given in parentheses. *Signicant at the 5 per cent level

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Table I. Estimates of the logit target prediction model based on the Beaver (1966) variables

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behaves likewise. The percentage of correctly classied companies during the estimation period is relatively high using the strong rm and the control rm samples. The results for the total rm sample are over-valued due to bankrupt rms having a very small weight in the total sample. On xing a cut-off equal to 0.5, the weak rm sample has high type I and II errors. In the total sample, the type I error is insignicant while the type II error is very high. The CAP and ROC measures indicate that a strong rm sample allows the model to be estimated with the best in-sample predictive capacity. The results concerning the Altman (1968), Altman et al. (1977) and Garca et al. (1997) models are likewise summarised in Tables II, III, and IV, respectively. In general, Tables II IV illustrate that the strong rm and control rm samples have the highest McFaddens R 2 in 2001 while the strong rm sample does so in 2002. The percentage of correctly classied companies during the estimation period is relatively high using the strong rms, from 82.35 per cent to 88.24 per cent. The CAP and ROC measures point out that the strong rm sample allows the model to be estimated with the best in-sample predictive capacity with values up to 0.9751. The total rm sample has the highest type II error, up to 99.41 per cent, which means that to predict that no rm is going to be bankrupt minimises the total error, since it represents a reduced percentage of the total number of rms used in the estimation process. On the other hand, the control rm sample shows different results depending on both the year and the model. In this sense, the percentage correctly classied goes from 64.71 per cent to 91.18 per cent, the type II error goes from 5.88 per cent to 35.29 per cent and the type I error goes from 5.88 per cent to 41.18 per cent. The CAP and ROC values of the control rm sample are lower than the strong rm sample and higher than the weak rm sample. The out-of-sample predictive capacity of the models is reported in Tables V and VI. When the total sample is considered to estimate the model, out-of-sample results cannot be computed in the estimation year. Concerning the strong rm sample, Table V reports that, in 2001, the type I error ranges from 24.38 per cent to 29.72 per cent, the type II error is equal to 11.76 per cent in all models and the CAP values go from 0.871 to 0.893 while the ROC values go from 0.7423 to 0.8520. These values do not worsen when the model is applied one or two years after the estimation. In the worst case, the type I error rises to 33.35 per cent, the type II error rises to 42.86 per cent, the CAP decreases to 0.801 and the ROC rises to 0.662. In general, the weak rm sample gives higher type I and II errors and lower ROC and CAP values than the strong rm and the control rm samples. The control rm sample has higher values of CAP and ROC as well as lower type I and II errors than the weak rm sample. In contrast, the total rm sample has the highest type II error. Table VI shows that, as in 2001, in 2002 the strong rm sample shows the most accuracy. Type I error in 2002 goes from 28.16 per cent to 30.76 per cent, type II error ranges from 5.88 per cent to 11.76 per cent in all the models and the CAP values go from 0.872 to 0.88 while ROC values go from 0.79 to 0.814. The results remain similar in 2003 and 2004. In the worst case, the type I error is 28.85 per cent, the type II error rises to 28.57 per cent, the CAP decreases to 0.785 and the ROC rises to 0.712. In general, the weak rm sample gives higher type I and II errors and lower ROC and CAP values than the strong rm and the control rm samples. It must be highlighted that the control rm sample has higher values of CAP and ROC and lower type I and II errors than the weak rm samples. In contrast, the total rm sample has the highest type II error.

Strong rms

2001 Weak rms Control rms Total rms Strong rms

2002 Weak rms Control rms

Total rms

Constant

WC

CP

ROA

CAP

ACT 20.29 0.0011 0.44305 82.35 23.53 11.76 0.9231 0.7424 70.59 35.29 23.53 0.8461 0.6007 88.24 17.65 5.88 0.8683 0.7171 99.32 0.64 83.03 0.7810 0.2702 88.24 17.65 5.88 0.9502 0.8022 7.80 0.1674 0.1655 27.42 0.0000 0.5817 54.82 0.0000 0.2749 25.37 0.0001 0.5383

2.24 * (1.28) 1.82 (3.07) 2 0.35 (7.15) 211.30 (9.96) 2 6.02 * (3.30) 0.04 (0.45) 0.75 (0.92) 21.62 (2.14) 1.77 (3.67) 4.43 (3.08) 23.35 (2.80) 20.03 (0.36) 21.51 (1.10) 5.32 (3.47) 9.82 * (5.90) 20.12 (4.94) 2 10.18 * (4.29) 2.06 * (0.89) 14.12 0.0148 0.2997 76.47 23.53 23.53 0.7303 0.4959 7.22 0.2046 0.1532 64.71 41.18 29.41 0.8980 0.6722 1.60 (1.58) 4.20 (4.48) 29.87 (9.13) 210.58 (7.88) 25.01 (3.08) 1.09 (0.82) 0.19 (1.16) 3.21 (2.64) 0.63 (6.53) 27.69 (5.97) 22.59 (2.39) 0.31 (0.51)

5.22 * (2.21) 1.62 (7.02) 2 2.97 (8.15) 234.83 * (17.60) 2 6.04 (5.06) 2 0.62 (0.47)

23.06 * (2.21) 22.16 (1.44) 2.34 (2.72) 28.14 * (3.70) 23.90 * (1.24) 20.17 (0.30)

2 2.76 * (0.64) 1.00 (1.81) 1.15 (3.56) 2 12.23 * (4.16) 2 5.97 * (2.25) 0.11 (0.26) 52.51 0.0000 0.2650 99.30 0.00 88.24 0.7687 0.2469

22 log L x 2 p-value McFadden R 2

Accuracy in-sample Percentage classied Type I error (per cent) Type II error (per cent) ARCAP ARROC

Notes: The sample was composed of 17 bankrupt rms. The dependent variable takes the value 1 for the 17 bankrupt rms and 0 for the non-bankrupt rms. Standard errors are shown in parentheses. *Signicant at the 5 per cent level

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Table II. Estimates of the logit target prediction model based on the Altman (1968) variables

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Constant

ROA

SROA

DS

CP

LIQ

CAP

SIZE 32.21 0.0000 0.6834 85.29 17.65 11.76 0.9751 0.7424 76.47 29.41 17.65 0.8682 0.7154 85.29 17.65 11.76 0.9162 0.7166 17.93 0.012 0.3805 27.57 0.0003 0.5850 62.22 0.0000 0.3120 99.41 0.00 76.47 0.7967 0.3130

22 log L x 2 p-value McFadden R 2

Accuracy in-sample Percentage classied Type I error (per cent) Type II error (per cent) ARCAP ARROC

Notes: The sample was composed of 17 bankrupt rms. The dependent variable takes the value 1 for the 17 bankrupt rms and 0 for the non-bankrupt rms. Standard errors are shown in parentheses. *Signicant at the 5 per cent level

Table III. Estimates of the logit target prediction model based on the Altman et al. (1977) variables Strong rms 16.77 (11.69) 2 4.95 (20.03) 174.31 (113.61) 1.23 (1.04) 9.75 (11.23) 24.81 (16.45) 256.31 (35.11) 2 1.47 (1.17) 20.65 (6.83) 22.83 * (10.36) 30.08 (21.06) 0.22 * (0.12) 5.40 (5.77) 20.63 (2.68) 213.14 * (6.34) 0.12 (0.71) 27.12 0.0003 0.5754 85.29 17.65 11.76 0.9661 0.8154 22.03 0.0025 0.4673 82.35 17.65 17.65 0.7936 0.5706 21.54 (3.46) 25.45 (3.98) 7.09 (4.88) 0.03 (0.08) 5.42 (3.31) 0.14 (1.80) 212.42 * (3.47) 20.15 (0.36) 7.29 (9.46) 239.09 * (19.42) 223.53 (24.46) 0.13 (0.32) 2 7.37 (8.90) 0.04 (9.51) 2 8.31 (11.61) 2 0.17 (1.01) 4.36 (8.15) 22.82 (8.90) 36.28 (29.70) 0.33 (0.41) 210.27 (9.87) 6.15 (5.62) 212.04 * (6.87) 20.19 (0.91) 13.71 (8.35) 17.12 (10.62) 53.51 * (22.78) 0.01 (0.13) 2.78 (7.18) 2.03 (4.34) 2 12.14 * (7.33) 21.45 * (0.86) 2001 Weak rms Control rms Total rms Strong rms 12.96 * (7.08) 26.87 (7.08) 12.04 (14.45) 0.40 (0.31) 21.64 (7.70) 6.32 (3.74) 27.09 (5.16) 21.32 * (0.75) 13.66 0.0575 0.2899 73.53 29.41 23.53 0.9389 0.7555 2002 Weak rms Control rms Total rms 0.26 (3.35) 2 9.03 * (4.51) 18.04 * (7.42) 0.02 (0.09) 0.30 (3.60) 1.79 (1.86) 2 9.88 * (3.34) 2 0.36 (0.37) 61.86 0.0000 0.3122 99.34 0.00 82.35 0.7853 0.2976

Strong rms

2001 Weak rms Control rms Total rms Strong rms

2002 Weak rms Control rms

Total rms

Constant

QLIQ

ATP

INT

AMO

EAR 26.49 0.0000 0.5620 88.24 11.76 11.76 0.9592 0.7987 61.76 35.29 41.18 0.8552 0.6295 91.18 5.88 11.76 0.8751 0.7599 99.28 0.05 88.24 0.8142 0.2601 88.24 17.65 5.88 0.9683 0.8147 10.50 0.062 0.2229 31.85 0.0000 0.6757 61.04 0.0000 0.3061 25.94 0.00000 0.5504

6.97 * (4.22) 1.85 (2.27) 2 8.78 * (4.38) 40.14 (35.38) 26.55 (17.97) 216.15 (9.86) 10.05 (6.78) 4.98 (3.92) 210.85 (6.80) 113.72 * (63.25) 2.18 (12.56) 228.63 (16.44) 9.55 0.0891 0.2025 67.65 35.29 29.41 0.7190 0.4764 5.69 0.3372 0.1208 64.71 35.29 35.29 0.8461 0.6183 2.48 (2.31) 22.16 (1.51) 22.76 (2.00) 6.91 (20.71) 4.29 (5.29) 21.66 (4.49)

5.97 * (2.76) 20.13 (1.43) 23.94 (2.42) 24.89 (8.24) 24.50 (5.21) 8.11 * (4.13)

3.38 * (1.94) 20.63 (0.99) 25.96 (1.71) 16.12 * (6.26) 20.06 (3.18) 26.82 * (3.07)

6.46 * (3.18) 1.77 (1.98) 26.77 * (2.71) 93.75 (58.40) 20.41 (6.57) 21.19 (5.61)

4.72 * (2.37) 0.45 (1.53) 22.15 (1.76) 2 21.34 (20.09) 2.88 (4.27) 2.85 (3.30)

1.56 (1.55) 2 1.14 (0.98) 2 3.93 * (1.11) 18.05 * (10.15) 2 0.88 (2.96) 2 9.74 * (3.13) 52.77 0.0000 0.2664 99.30 0.00 88.24 0.7744 0.2353

22 log L x 2 p-value McFaden R 2

Accuracy in-sample Percentage classied Type I error (per cent) Type II error (per cent) ARCAP ARROC

Notes: The sample was composed of 17 bankrupt rms. The dependent variable takes the value 1 for the 17 bankrupt rms and 0 for the non-bankrupt rms. Standard errors are shown in parentheses. *Signicant at the 5 per cent level

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Table IV. Estimates of the logit target prediction model based on the Garca et al. (1997) variables

74

JSBED 17,1

Beaver (1968) Type I error 29.72 Type II error 11.76 ARCAP 0.8398 ARROC 0.7625 70.65 17.65 0.5316 0.7006 5.88 0.7484 0.7586 23.53 0.801 0.733 35.29 0.473 0.598 23.53 0.713 0.679 94.12 0.786 0.212 14.29 0.834 0.816 32.63 29.11 67.16 33.46 0.00 33.35

Altman (1968) Type I error 24.38 Type II error 11.76 ARCAP 0.8937 ARROC 0.7423 26.39 23.53 0.7843 0.6007 5.88 0.8305 0.7171 23.53 0.873 0.721 29.41 0.738 0.571 17.65 0.813 0.646 28.08 22.91 24.14 27.45 0.00 94.12 0.747 0.221

Altman et al. Type I error Type II error ARCAP ARROC 44.35 17.65 0.7504 0.7166 11.76 0.7744 0.7154 35.29 0.801 0.662 41.18 0.674 0.629 27.53 26.31 41.65

Garca et al. (1997) Type I error 24.48 Type II error 11.76 ARCAP 0.8711 ARROC 0.7987 47.90 47.06 0.7007 0.6295 11.76 0.8058 0.7599 26.71

Note: The out-of-sample predictive ability of the models is measured on the whole population of rms in 2001, 2002 and 2003

Table V. Out-of-sample accuracy of the models estimated in 2001 2001 Weak rms Control rms Total rms Strong rms Weak rms Control rms Total rms Strong rms Weak rms 2002 2003 Control rms Total rms 65.39 14.29 0.512 0.652 37.63 14.29 0.771 0.776 0.48 85.71 0.786 0.321 23.48 14.29 0.873 0.737 23.48 28.57 0.775 0.578 28.94 14.29 0.838 0.710 0.48 85.71 0.759 0.300 27.54 17.65 0.740 0.654 0.00 88.24 0.749 0.263 22.74 28.57 0.844 0.725 36.53 28.57 0.775 0.714 28.33 14.29 0.786 0.736 0.83 71.43 0.781 0.361 24.94 35.29 0.809 0.681 46.10 29.41 0.742 0.644 25.93 17.65 0.743 0.680 0.005 94.12 0.785 0.224 25.67 14.29 0.846 0.799 41.34 42.86 0.698 0.577 25.01 14.29 0.765 0.706 0.48 85.71 0.783 0.313

Strong rms

(1977)

26.16

11.76 0.8818 0.8520

2002 Weak rms Control rms Total rms Strong rms Weak rms Control rms Total rms Strong rms Weak rms Control rms Total rms

2003

2004

Strong rms

24.89 29.41 0.406 0.573 23.53 0.835 0.616 11.76 0.879 0.790 23.53 0.429 0.515 11.76 0.733 0.630 29.41 0.796 0.408 14.29 0.856 0.831 57.14 0.473 0.447 28.57 0.622 0.681

61.24

28.85

23.83

63.38

1.14

28.18

23.27

63.74

1.31 42.86 0.754 0.577

Beaver (1968) Type I error 28.96 Type II error 11.76 ARCAP 0.880 ARROC 0.790

31.52 17.65 0.740 0.495 29.41 0.776 0.672 5.88 0.849 0.775 5.88 0.744 0.540 11.76 0.813 0.745 35.29 0.774 0.333 28.57 0.785 0.712

20.78

28.11

30.99

23.09

0.71

26.53

30.26 28.57 0.714 0.669

22.93 14.29 0.759 0.680

0.65 42.86 0.763 0.528

Altman (1968) Type I error 28.16 Type II error 5.88 ARCAP 0.873 ARROC 0.802

40.51 17.65 0.716 0.570 23.53 0.779 0.775 5.88 0.856 0.774 11.76 0.758 0.645 11.76 0.787 0.721 29.41 0.773 0.367

26.93

23.83

39.02

21.30

0.95

23.32 28.57 0.815 0.736

34.04 0.00 0.814 0.726

20.67 14.29 0.812 0.756

0.87 28.57 0.763 0.606

Altman et al. (1977) Type I error 28.58 Type II error 11.76 ARCAP 0.877 ARROC 0.815

38.81 29.41 0.743 0.476 35.29 0.746 0.618 11.76 0.853 0.754 5.88 0.754 0.524

16.33

27.72

37.84

17.50 11.76 0.806 0.678

0.52 35.29 0.788 0.314

25.71 14.29 0.850 0.827

36.04 42.86 0.605 0.487

17.76 14.29 0.758 0.615

0.48 57.14 0.745 0.398

Garca et al. (1997) Type I error 30.76 Type II error 5.88 ARCAP 0.872 ARROC 0.814

Note: The out-of-sample predictive ability of the models is measured on the whole population of rms in 2001, 2002 and 2003

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Table VI. Out-of-sample accuracy of the models estimated in 2002

JSBED 17,1

76

Conclusions Many efforts have been devoted to developing models to predict bankruptcy probability and banks, investors and rms are interested in using these models. However, since the models have been developed in the aim to estimate the bankruptcy probability of quoted rms, less attention has been paid to non-quoted SMEs. Usually, the bankruptcy probability of non-quoted SMEs is studied by analysing nancial ratios using discriminating techniques. These models are based on constructing an estimation sample using bankrupt and non-bankrupt rms, controlling by size and industry or unbalancing the sample using all rms. In our article, we propose an alternative to control the heterogeneity of healthy rms. In doing this, we construct a nancial health indicator to dene the degree of nancial health. Our results are obtained under four different models of credit scoring. We show in-sample and out-of-sample bankruptcy predictions. We apply measures proposed by the Basel Committee on Banking Supervision to evaluate the credit scoring of the models depending on the criterion considered to select the rms. Focusing on the non-bankrupt rms, the nancial health indicator allows rms to be classied before the estimation process. This procedure permits the heterogeneity of the rms to be reduced as well as identifying a strong rm sample to estimate the bankruptcy probability accurately. The in-sample and out-of-sample evaluation based on the CAP and ROC indicators, proposed by the BCBS, leads to the conclusion that the models estimated under the strong rm sample are much more accurate.
References Altman, E.I. (1968), Financial ratios, discriminant analysis and the prediction of corporate bankruptcy, Journal of Finance, Vol. 23 No. 4, pp. 589-609. Altman, E.I. and Saunders, A. (1998), Credit risk measurement: developments over the last 20 years, Journal of Banking and Finance, Vol. 21, pp. 1721-42. Altman, E.I., Haldeman, E. and Narayanan, P. (1977), Z analysis: a new model to identify bankruptcy risk of corporations, Journal of Banking and Finance, Vol. 10, pp. 29-54. Basel Committee on Banking Supervision (2005), Studies on the validation of internal rating systems, Working Paper No. 14, Basel Committee on Banking Supervision, Basel. Beaver, W.H. (1966), Financial ratios as predictor of failure, Empirical Research in Accounting: Selected Studies, Supplement to Journal of Accounting Research, Vol. 5, pp. 71-111. Beaver, W.H. (1968), Alternative accounting measures as predictor of failure, The Accounting Review, Autumn, pp. 112-22. Berryman, J. (1983), Small business failure and bankruptcy: a survey of the literature, European Small Business Journal, Vol. 1 No. 4, pp. 47-59. Carter, R. and Van Auken, H. (2006), Small rm bankruptcy, Journal of Small Business Management, Vol. 44 No. 4, pp. 493-512. Cochran, B. (1986), Small business mortality rates: a review of the literature, Journal of Small Business Management, Vol. 19 No. 4, pp. 50-9. Craig, B., Jackson, W. and Thomson, J. (2003), On SBA-guaranteed lending and economic growth, working paper, Federal Reserve Bank of Cleveland, Cleveland, OH, April. Edmister, R. (1972), An empirical test of nancial ratio analysis for small business failure prediction, Journal of Financial and Quantitative Analysis, Vol. 7 No. 2, pp. 1477-93.

Engelmann, B., Hayden, E. and Tasche, D. (2003), Testing rating accuracy, Risk, January, pp. 82-6. Fredland, J. and Morris, E. (1976), A cross section analysis of small business failure, American Journal of Small Business, Vol. 1, July, pp. 7-18. Garca, D., Arques, A. and Calvo-Flores, A. (1997), Un modelo discriminante para evaluar el riesgo bancario en los creditos a empresas, Revista Espanola de Financiacion y Contabilidad, Vol. 24 No. 82, pp. 175-200. Hall, G. and Young, B. (1991), Factors associated with insolvency amongst small rms, International Small Business Journal, Vol. 9 No. 2, pp. 54-63. Headd, B. (2003), Redening business success: distinguishing between closure and failure, Small Business Economics, Vol. 21, pp. 51-61. Thedodossious, P., Kahya, E., Saidi, R. and Philippatos, G. (1996), Financial distress and corporate acquisitions: further empirical evidence, Journal of Business Finance and Accounting, Vol. 23, pp. 699-719. Watson, J. and Everett, J. (1996), Do small business have high failure rates?, Journal of Small Business Management, Vol. 34 No. 4, pp. 45-52. Watson, J. and Everett, J. (1999), Small business failure rates: choice of denition and industry effects, International Small Business Journal, Vol. 17 No. 2, pp. 31-47. Zingales, L. (2000), In search of new foundations, Journal of Finance, Vol. 55 No. 4, pp. 1623-53. About the authors J. Samuel Baixauli is an Associate Professor at the Department of Management and Finance at the University of Murcia, Spain. He received his PhD in Business Administration for work on nancial economics. He has been research visitor at the Department of Economics at the University of York, UK. His main research areas include nancial modeling and estimation of market and credit risk. He has published on these topics in international journals such as European Journal of Operational Research, Journal of Financial Research, Review of Quantitative Finance and Accounting and European Journal of Finance. J. Samuel Baixauli is the corresponding author and can be contacted at: sbaixaul@um.es Antonina Modica-Milo is an Associate Professor at the Department of Management and Finance at the University of Oriente, Venezuela. She received her PhD in Business Economics from the Department of Management and Finance at the University of Murcia, Spain. Her main research areas include nancial modeling and estimation of credit risk. She has experience working as a nancial advisor for relevant private companies.

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