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  Using Ratios to Predict Financial Failure

Introduction to Using Ratios to Predict Financial Failure

Financial ratios that based on current or past performance are frequently employed to help predict the future. Though, both the choice of ratios and the interpretation of results are generally relies on the judgement and opinion of the analyst. In current years, though, attempts have been made to build up a more exact and systematic approach to make use of ratios for prediction aims. Particularly, researchers have displayed an interest in the ability of ratios to predict the financial failure of a business.

Through financial failure, we mean a business either being forced out of business or being strictly adversely influenced through its inability to meet its financial obligations. It is frequently considered as 'going bust' or 'going bankrupt'. Certainly, this is an area with which all those related with the business are possible to be concerned.

Using single ratios

Several approaches which attempt to make use of ratios to predict future financial failure have been developed. Early research, that is focused on the examination of ratios on an individual basis to see whether they were bad or good predictors of financial failure.

Using combinations of ratios

The weaknesses of univariate analysis have led researchers to build up models that combine ratios in such type of way like to generate a single index which can be interpreted more visibly. One way to model development, much favoured through researchers, applies multiple discriminate analyses (MDA).

Z-score models

Altman was the first who build up a model (in year 1968), by using financial ratios, which was capable to predict financial failure. In year 2000 he revised that model. Actually, the revisions essential to make the model effectual in present times were quite minor.

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