Predicting corporate bankruptcy using multivariant discriminate analysis (MDA), logistic regression and operating cash flows (OCF) ratio analysis A Cash Flow-Based Approach

PREDICTING CORPORATE BANKRUPTCY USING MULTIVARIANT
DISCRIMINATE ANALYSIS
(MDA),
LOGISTIC REGRESSION AND
OPERATING CASH FLOWS (OCF) RATIO ANALYSIS:
A Cash Flow-Based Approach
By
Christopher Scott Rodgers
for
Golden Gate University
San Francisco, CA
UMI Number 3459530
All rights reserved
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DISSERTATION

Title:
PREDICTING CORPORATE BANKRUPTCY USING MULTIVARIANT
DISCRIMINATE ANALYSIS
(MDA),
LOGISTIC REGRESSION AND
OPERATING CASH FLOWS (OCF) RATIO ANALYSIS:
A Cash Flow-Based Approach
Christopher Scott Rodgers
Submitted in Partial Satisfaction
of the requirements for the degree of
Doctor of Business Administration
AGENO SCHOOL OF BUSINESS
GOLDEN GATE UNIVERSITY
Hamid Shomali, Ph.D.
iTkfeGbsfci
(J&<UM
Vi
Miro Costa, Ph.D David Hua, Ph D
DATE:
May 2011
1
PREDICTING CORPORATE BANKRUPTCY USING MULTIVARIANT
DISCRIMINATE ANALYSIS
(MDA),
LOGISTIC REGRESSION AND
OPERATING CASH FLOWS (OCF) RATIO ANALYSIS:
A Cash Flow-Based Approach
Christopher Scott Rodgers
Golden Gate University, 2011
Abstract

In this paper,
we
will discuss current solvency
evaluation methods, explore their inherent weaknesses
and
propose
a
cash flow-based alternative that
may be
more
effective
m
identifying candidates that
are
susceptible
to
financial failure.
We
believe this research will benefit
corporate business managers
of
both public
and
private
firms
m
helping them
to
identify
and to

take constructive
action
to
correct potentially crippling situations.
We
also believe
it
will
be of
value
to
equity
and
debt
investors,
by
providing them with more timely
and
accurate
analysis
for
investment decisions. Lastly,
it
should
be of
value
to
auditors
in
assessing

a
firm ability
to
continue
as
a
Agoing concern'
and
issuing opinions.
1
Dedication
I would like to thank my wife, Candace and my family
for their patience and support during this endeavor.
I would also like to thank the fine academic
institutions I have served during this period for their
contribution to the successful completion of this project.
I would especially like to thank my committee, Dr.
Hamid Shomali, Dr. Miro Costa, and Dr. David Hua for their
direction, assistance and support.
I would also like to thank Dr. Nabil Rageh, my program
director for his understanding and consideration of the
circumstances I faced while on this journey.
I would also like to dedicate the substance of this
work in loving memory of my father, Garland, who saw in me
what I could not see in myself.
Without the help of the aforementioned entities, none
of this work would have been possible.
11
Table of Contents:
0 Introduction

11 Objectives of the Study
1 2 Background
0 Review of Literature
2 1 Bankruptcy An Overview
2 2 Financial Failure in the United States
2 2 1 Financial Failures (1980 to 1999)
2 2 2 Financial Crisis in the Early 2000's
2 2 3 Financial Crisis in the Late 2000's
2 2 4 Financial Failures 2010 and beyond
2 3 Traditional Financial Ratio Analysis
2 4 Ratio Analysis as a Predictor of Bankruptcy
2 5 Weaknesses of Accrual-Based Ratios
2 6 Growth Rates and Insolvency
2 7 Analyzing the Statement of
Cash
Flows
2 8 Capital Structure and Insolvency
2 9 Quarterly Versus Audited Financial Statements
2 10 Cash Flow-Based Ratios and Analysis
0 Methodology
3 1 The Scope of the Study
3 11 The Bankrupt Sample
3 12 The Non-Bankrupt Sample
3 2 Procedures for Analysis of the Financial Statements
3 2 1 Cash Flow-Based Ratios Used in the Study
3 2 2 Calculations and Adjustments Employed
3 3 Statistical Methods Employed
3 3 1 Using Traditional Regression Analysis
3 3 2 Refining Results Using Logistical Regression
3 3 3 Expected Contributions of the Methods Selected

3 4 Hypothesis Testing
3 4 1 Testing Hypothesis 1
3 4 2 Testing Hypothesis 2
3 4 3 Testing Hypothesis 3
4 0 Findings
4 1 Results of Hypothesis Testing
4 11 Results of Testing Hypothesis 1
4 12 Results of
Testing
Hypothesis 2
4 13 Results of Testing Hypothesis 3
4 2 Testing the Holdout Sample
4 2 1 Testing Using Descriptive Statistics
4 2 2 Testing Using the T-Statistic
4 3 The Z-Score Ratios and Their Justification
5 0 Conclusions and Recommendations
5 1 Conclusions Drawn from the Study
5 2 Recommended Use of Study Results
5 3 Suggestions for Future Research
5 3 1 Further Z-Score Testing of Financial Institutions
5 3 2 Testing Solvent Periods of Bankrupt Sample
5 3 3 Development of a Hybrid Score
5 3 4 Testing Market Indexes Components with Z-Score
5 3 5 Testing Our Model Against Altman's Z-Score
5 4 In Closing
l_AIIIUIl3
• • • •• a a a a •• •• •• a •••• aaa • • •• a
Exhibit 1 List of Bankrupt Companies
Exhibit 2 List of Non-Bankrupt Companies
Exhibit 3 List of

Cash
Flow-Based Ratios
Exhibit 4 MDA Run (37 Ratio
Tested,
All Companies)
Exhibit 5 MDA Test Results 37 Ratios-80 Companies
Exhibit 6 MDA Test Results 30 Ratios-80 Companies
Exhibit 7 VIF Run (Top Five Ratios)
Exhibit 8 Logistic Regression Run (Top Five Ratios)
Exhibit 9 Z-Scores for Bankrupts Firms (Six Quarters)
Exhibit 10 Z-Scores for Non-Bankrupt Firms (Six Quarters)
Exhibit 11 Original Non-Bankrupt Sample vs Original Bankrupt Sample
Exhibit 12 Summary of Z-Score Fails
Exhibit 13 Z-Scores for Hold Out Samples
Exhibit 14 Original Bankrupt Sample vs Bankrupt Hold Out Sample
Exhibit 15 Original Non-Bankrupt Sample vs Non-Bankrupt Hold Out Sample
Exhibit 16 Bankrupt Hold Out Sample vs Non-Bankrupt Hold Out Sample
References
PREDICTING CORPORATE BANKRUPTCY USING MULTIVARIANT
DISCRIMINATE ANALYSIS
(MDA),
LOGISTIC REGRESSION AND
OPERATING CASH FLOW (OCF) RATIO ANALYSIS:
A Cash Flow-Based Approach
Chapter 1: Introduction
1 1 Objectives of the Study
In this paper, we will discuss current solvency
evaluation methods, explore their inherent weaknesses and
propose a cash flow-based alternative that may be more
effective in identifying candidates that are susceptible to

financial failure. We believe this research will benefit
corporate business managers of both public and private
firms in helping them to identify and to take constructive
action to correct potentially crippling situations. We
also believe it will be of value to equity and debt
investors,
by providing them with more timely and accurate
analysis for investment decisions. Lastly, it should be of
value to auditors in assessing a firm's ability to continue
as a 'going concern' and issuing opinions.
In order to accomplish these objectives we will be
evaluating financial statements using ratios derived
primarily from cash flow statement data. Our initial
1
samples will include 30 of the largest corporate
bankruptcies that have occurred in the last 20 years and 30
of the best performing firms based on their five-year
return to stockholders. Cash flow-based ratios will be
calculated for these 60 firms then statistically evaluated,
first using backward-regression, and then re-evaluated
using logistic regression. We intend to develop a
z-score
by using the coefficients determined by logistic regression
then retesting both samples to evaluate how accurate and
effective the model is in properly classifying the firms as
either bankrupt or non-bankrupt. We will then retest the
model using a holdout sample of ten bankrupt and ten non-
bankrupt companies to further validate its effectiveness.
We believe that the
z-score

developed in this study
will be effective in identifying and classifying 'at risk'
companies and will assist managers, creditors and
evaluators as a screening tool for solvency. We further
believe this
tool,
along with other analysis, can lead to
better solvency and risk assessment decisions.
1 2 Background
Twenty of the largest corporate bankruptcies in U.S.
history have occurred since 1987. (bankruptcydata.com)
Although some of these business failures, such as General
2
Motors,
K-Mart and United Airlines, were telegraphed
through press releases and careful analysis of their
financial statements and well anticipated by creditors and
investors alike, others, such as Enron, Global Crossing and
WorldCom, slipped below the radar, avoiding detection until
after their public announcements. This inability of
traditional analysis to detect these massive failures has
cost investors and creditors billions of dollars and
weakened the public's faith in the soundness of the
securities analysis industry and other watchdog
institutions responsible for keeping the public educated
and informed (Anand,
2007).
3
Chapter 2: Review of Literature
2.1 Bankruptcy

*
An Overview
The act of declaring bankruptcy is typically the final step
in a series of managerial miscalculations, oversights and
failed strategies (Bhandari & Weiss,
1996).
When these
management failures are combined with adverse external
events,
extensive degrees of insolvency can result,
jeopardizing and in some cases terminating the potential
long-term existence of a previously productive and solvent
entity
(ibid).
Most analysts agree that the events that
lead up to insolvency do not happen overnight and in
hindsight, careful analysis of their past performance is
generally sufficient in uncovering warning signs that may
have been missed by most, if not all, of private and public
analysts (Muro,
1998).
In 1991, Dun and Bradstreet (D&B) reported that 41% of
corporate bankruptcies in the United States were attributed
to economic factors driven by forces outside of the
influence and control of the average firm. These factors
manifest themselves in the form of industry weakness and
insufficient profit margins, and are commonly induced by
changes in interest rates, competition, government
regulation and weak economic growth
(ibid).

4
D&B also cited that finance factors, such as heavy
operating expenses and insufficient capital as the second
most common causes at
32.5%.
They observed that some firms
actually grow themselves into insolvency by failing to
secure adequate sources of capital or by losing control of
their expenses and efficiency ratios through ineffective
asset and liability management.
Experience factors, such as lack of business knowledge
and management experience were third at
20.6%.
These
failures may also be attributed to excessive growth and
insufficient planning and are characterized by entering new
markets prematurely, promoting underqualifled personnel
from within, or failing to seek professional assistance
when required
(ibid).
The D&B study noted neglect factors (2 5%), such as
poor work habits and business conflicts can also be a sign
of management failure. Firms that are too immature or too
complacent can fall into this category. D&B also cited
fraud
(1.2%),
disaster
(1.1%),
and inappropriate strategy
(1.1%) as minor factors. D&B also observed that over 50%

of bankrupt firms were over 5 years old at the time they
initially filed for protection from creditors, suggesting
that age might not be a critical factor.
5
Most distressed firms do not become bankrupt, (Hill
and Perry,
1996).
In some cases the cause of financial
distress is temporary allowing the firm to file a
reorganization plan and continue operations or merge with
another, more solvent firm, (Gilbert, Menon, & Schwartz,
1990).
In other cases, the causes were determined to be
permanent in nature and the firms were liquidated in order
to satisfy some, if only a very few of the firms' formal
stakeholders and creditors. (Moyer, McGuigan, & Kretlow
1998)
Before firms are forced to seek protection from their
stakeholders and creditors in the form of bankruptcy, most
firms experience the identifiable stages commonly known as
technical insolvency, legal insolvency and default. Giroux
and Wiggins (1983) observed that common business failures
begin with lower than expected operating results and the
reduction or elimination of dividends. Flagg and Giroux,
(1991),
identified and investigated four potential overt
symptoms of financial distress, namely dividend reductions,
"going concern" qualified opinions, debt restructuring
problems,
and violations of debt covenants

(ibid).
These
events may be considered minor or temporary at first, until
they are followed by net losses and negative changes in
6
operating cash flow. Reduction in bond and other credit
ratings followed by deteriorating operating results may
also be precursors to debt accommodation and default
(ibid).
Bathory (1984) identified three distinct
classifications of financial distress; acute, chronic, and
terminal.
In acute insolvency cases, the firms past
performance had been considered satisfactory until these
firms experienced periods of insufficient cash to meet its
short-term financial obligations, either through the
inability to collect receivables or to secure short-term
sources of credit. In contrast, the chronically insolvent
firms had displayed unsatisfactory or declining performance
for years These firms have difficulties meeting mid- to
long-term financial obligations and over rely on trade
credit and collateralizing their assets. Terminally
insolvent firms, like chronically insolvent firms display
unsatisfactory or declining performance, but are now unable
to fund permanent changes in their balance sheet, have
misaligned cash-flow patterns and may only be in business
because they are considered 'too big to
fail'
or a
'national interest'

(ibid).
7
Bathory attributes poor management, unprofitable
subsidiaries, divisions or product lines, as well as
cyclical,
economic and legal-political factors as causes
for acute insolvency and poor credit control, low or
eroding profit margins and slow asset turnover as causes
for chronic and terminal insolvency.
Although most traditional analysis attempts to
identify these causes and symptoms by using accrual-based
analysis methods, the entrance into each of these stages
may be more of a result of inadequate operating cash flow
rather than a lack of accrued income and profit. It is not
unusual for a troubled firm to have positive profit margins
and still be unable to meet its current cash-flow needs.
Zeller and Stanko (1994) demonstrated that accrual-based
analysis occasionally failed to reveal the severe liquidity
problems that can lead to corporate failure.
2.2 Financial Failures in the United States
Financial failure over the past 30 years has been
driven primarily by economic cycles, deregulation,
technological innovations, and in some cases financial
mismanagement and fraud (Hamilton & Micklethwait,
2006).
8
2 2.1 Financial Failures (1980 to 1999)
The majority of financial failures in the 1980's were
due to deregulation of the Airline and the Savings and Loan
Industries and federal income tax law changes (Sornette,

2003).
Airline industry deregulation forced airlines to
become more competitive and although it led to more
competition and lower airfares, it changed the operating
environment severely for the larger U.S. carriers (Viscusi,
Vernon & Harrington,
1995).
Most foreign carriers were not
affected by the U.S. regulations and many had their
operating costs highly subsidized by their home governments
(Hanlon,
2007).
Shortly afterwards, several major U.S.
carriers,
including Pan Am, Eastern, Continental, America
West and Trans World filed for bankruptcy protection along
with dozens of smaller U.S. airlines (Patashnik,
2008).
Deregulation of the Savings and Loan Industry allowed
S&L's to compete for deposits with commercial banks by
offering a wider array of savings products as well as
expanding their lending authority (Berman & Irons-Georges,
2008).
As a result, S&L's became more aggressive in their
lending policies and in securing funds (Calavit, Pontell &
Tillman,
1997)
.
This strategy led to a mismatch of long-
term assets being funded by short-term liabilities

(ibid).
9
Real estate prices soared as investors and speculators
began buying up multiple properties, driving prices and
interest rates even higher
(ibid).
Then in 1986, tax reform legislation changed the real
estate investment environment by limiting federal income
tax write-offs for private individuals' associated passive
investments,
leaving many investors with negative after tax
cash flows on their rental properties. (Berman & Irons-
Georges,
2008).
As defaults on mortgages began to
increase,
the value of the underlying assets began to fall
(ibid).
Soon the S&L's were being required to repurchase
their underperforming loans
(ibid).
Investors in mortgage-
based securities began to enforce higher quality standards
for conventional loans and many S&L's were being required
to portfolio their loans, tying up valuable funds
(ibid).
Desperate to find new sources of funds, the S&L's began to
offer more exotic savings products to their customers.
This included high-yield derivative products also known as
junk bonds (Calavita, Pontell & Tillman,

1997).
Junk bond
king,
Michael Milken, Charles Keating, and Drexel Burnham
transformed Lincoln Savings & Loan from a home mortgage
leader into a land developer, junk bond originator and
leveraged buy-out company (McCauley, Ruud & Iacono,
1999).
10
Other funding-starved S&L's began to adopt the Lincoln
model and when the bottom fell out, nearly 25% of the S&L's
in the United States had disappeared and with them, the
life savings of thousands of depositors. (Canterbery,
2006).
2.2.2 The Financial Crisis in the Early 2000's
Most analysts agree that the financial crisis of the
early 2000's were due to corporate greed and terrorism
(Matulich & Currie,
2009).
It began with the 'Dot.com'
bust,
was exacerbated by the corporate scandals of the
early 2000's, and climaxed after 9/11. The unprecedented
rise in stock prices in the late 1990's created unrealistic
expectations of many stockholders and corporate executives
(Sornette,
2003).
Even after the market crash, many
corporate executives, in order to ensure stable and even
increasing stock prices, 'cooked the books' (Matulich &

Curry,
2009).
Even CPA firms, like Arthur Anderson,
succumbed, realizing they could profit more from consulting
than auditing, top management required their auditors to
find ways to 'make it work'
(ibid).
Dennis Kozlowski, the
former chairman of Tyco was accused and convicted of
overstating profits and inappropriate use of corporate
funds (Markham,
2006).
Adelphia Communications, WorldCom
11
and Enron Corporation filed for bankruptcy protection
shortly after their accounting scandals were reported,
leading to three of the largest bankruptcies in United
States history (Hamilton & Micklethwait,
2006).
Just when it appeared that a major global financial
catastrophe could be avoided, the 9/11 terrorist attacks
occurred and again the financial markets around the world
tumbled. Shortly afterwards, United and US Airlines filed
for bankruptcy protection. Retail giant K-mart and
insurance conglomerate Conseco also failed. It would take
at least another three years before confidence in the
market and its oversight would be effectively restored
(Anand,
2007).
2.2.3 The Financial Crisis in the Late

2000'
s
The financial crisis that began in 2007 is believed by
many economists to be the worst global crisis since the
Great Depression of the 1930's (Roubini,
2009).
Its
origins can be traced back to the 1999 repeal of the Glass-
Steagall Act of 1933 that previously prohibited depository
banks from engaging in speculative activities commonly
reserved for investment banking companies
(ibid).
This
fundamental change in the banking environment led to
commercial banks and federal mortgage entities having to
12
compete with Wall Street for quality mortgages. This
increase in capital and competition led to a lowering of
standards,
excessive mortgage liquidity and a housing
bubble that began to collapse in
2006.
(O'Brien,
2009).
Eventually, many of the subprime borrowers began to have
problems making their mortgage payments, leading to default
and eventually foreclosure
(ibid).
Once the value of the
underlying assets that securitized the mortgages fell below

the value of the securities, defaults began to accelerate
and the securities held by the banks and other mortgage
investment entities declined in value as well (Muolo &
Padilla,
2008).
This valuation issue was exacerbated by
the 'mark-to-market' rule that required banks to report
their mortgage-backed securities at the lower of their face
or market value (Barth, 2009) This adjustment to the
value of the securities greatly reduced the value of bank
assets and restricted a bank's ability to lend and maintain
the margin requirements monitored by the Federal Reserve.
This lack of margin led to a global liquidity crisis that
further contributed to the downfall of major commercial
banks world-wide
(ibid).
Eventually, the troubles of Wall
Street spilled over onto Main Street. The liquidity crisis
led to a drying up of credit and adversely reduced
13
consumers and businesses ability to secure credit for
large-ticket purchases and acquisitions (Muolo & Padilla,
2008).
The corresponding reduction of consumer and
business demand led to reductions in production and layoffs
(ibid) .
This in turn led to more defaults, further write-
down of bank assets and more financial failure
(ibid).
In the United States, Lehman Brothers, Indy Mac

Bancorp, Washington Mutual, and many other financial
institutions collapsed. Later General Motors, Chrysler and
retailers began to
fail.
In an attempt to stem the tide,
governments of capitalist nations have taken unprecedented
actions to partially or completely take-over failing
institutions (O'Brien,
2009).
At the time of this paper,
the issue still appears to be somewhat stable, but yet
unresolved
2.2.4 Financial Failures 2010 and Beyond
Since 2010, most of the financial failures have been
related to economic cycles and have included retailers like
Blockbuster, Borders and several small to mid-sized banks.
Analysts are divided as to whether recent government
reforms and oversight will reduce the likelihood of future
financial meltdowns, but most agree that Sarbanes-Oxley,
Dodd-Frank and increased oversight by the Security and
14
Exchange Commission (SEC) should provide some additional
protections to the investing and consuming public (Sweeney,
2011)
.
The Sarbanes-Oxley Act, also known as the 'Public
Company Accounting Reform and Investor Protection Act' was
passed into law in
2002,
shortly after the Enron, WorldCom,

Tyco,
Adelphia and Peregrine Systems scandals weakened the
public confidence in the U.S. securities markets (Green,
2004).
The law set new and enhanced standards for all U.S.
public boards, corporate management and public accounting
firms
(ibid).
The law contains eleven specific mandates and
requirements for public reporting, including the
establishment of a Public Company Accounting Oversight
Board
(PCAOB),
enhanced standards for auditor independence,
individual responsibility for 'principle officers',
enhanced financial disclosures, disclosure of conflicts of
interest and codes of conduct for analysts, protection for
'whistle-blowers', and criminal and financial penalties for
fraud, destruction or alteration of financial records, and
interfering with government investigations (Anand,
2007)
.
The three provisions that are expected to have the most
profound effect on the issuance of fraudulent financial
statements are the Auditor Independence, Corporate
15
Responsibility and Corporate Fraud Accountability
Provisions (Green, 2004)
The Public Company Accounting Oversight Board (PCAOB)
was established to provide independent oversight of public

accounting firms providing audit services (Anand,
2007).
In the past, CPA firms were expected to monitor and
regulate themselves and to adhere to a rigid code of ethics
(ibid).
Arthur Anderson and its participation in the
Enron,
WorldCom and Global Crossing scandals has made this
previous assumption of self-regulation inoperable
(ibid).
The PCAOB provision creates a central oversight board
responsible for registering auditors, defining specific
processes and procedures for compliance audits, inspecting
and policing conduct and quality control and enforcing
compliance with the mandates of Sarbanes-Oxley (Green,
2004).
The jury is still out with regards to the Dodd-Frank
Wall Street Reform and Consumer Protection Act of 2010,
which was passed in the aftermath of the subprime mortgage
crisis (Sweenney,
2011).
The law is expected to strengthen
the ability of government investigators with new rules and
penalties in the effort to target and uncover 'white-
collar'
crime and rewards for 'whistle-blowers' who are
16
willing
to
come forward

and
cooperate with government
investigators
(ibid).
The law
contains sixteen titles,
creates
243 new
rules, conducts
67
studies
and
requires
the
issuance
of 22
periodic reports (DavisPolk,
2010) .
The
stated purpose
of the law is:
"to promote the financial stability of the United
States by improving accountability and
transparency in the financial system, to end "too
big to fail", to protect the American taxpayer by
ending bailouts, to protect consumers from
abusive financial services practices, and for
other purposes" (HR 4173)
The
law

gives
the
Federal Government
the
power
to
'promote market discipline'
and
oversee
the
liquidation
of
bank assets
in
receivership.
It
also enumerates
the
authority
of the
Federal Reserve, FDIC
and the
Comptroller
of
the
Currency, introduces significant regulation with
regards
to
hedge funds
and

similar investment
intermediaries, establishes
a
'Federal Insurance Office',
distinguishes between banking
and
nonbank financial
transactions, requires more transparency
and
accountability
from Wall Street, enhances
the
role
of the
Federal Reserve
with regards
to
payments, clearing
and
settlement,
increases
the
role
of
government
in the
area
of
investor
protection, improves oversight

of
credit rating agencies,
creates
the
Bureau
of
Consumer Financial Protection,
17