Financial Ratios As Predictors of Failure

Abstract

At the turn of the century, analysis was in its embryonic state. It began with the development of a single ratio, the current ratio,' for a single purpose-the evaluation of credit-worthiness. Today analysis involves the use of several ratios by a variety of users-including credit lenders, credit-rating agencies, investors, and management.2 In spite of the ubiquity of ratios, little effort has been directed toward the formal empirical verification of their usefulness. The usefulness of ratios can only be tested with regard to some particular purpose. The purpose chosen here was the prediction of failure, since ratios are currently in widespread use as predictors of failure. This is not the only possible use of ratios but is a starting point from which to build an empirical verification of analysis. Failure is defined as the inability of a firm to pay its obligations as they mature. Operationally, a firm is said to have failed when any of the following events have occurred: bankruptcy, bond default, an overdrawn bank account, or nonpayment of a preferred stock dividend.3 A financial ratio is a quotient of two numbers, where both num-

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