The duality of bankruptcy process in Finland

Abstract

Standard bankruptcy prediction methods lead to models weighted by the types of failure firms included in the estimation sample. These kinds of weighted models may lead to severe classification errors when they are applied to such types of failing (and non-failing) firms which are in the minority in the estimation sample (frequency effect). The purpose of this study is to present a bankruptcy prediction method based on identifying two different failure types, i.e. the solidity and liquidity bankruptcy firms, to avoid the frequency effect. Both of the types are depicted by a theoretical gambler's ruin model of its own to yield an approximation of failure probability separately for both types. These models are applied to the data of randomly selected Finnish bankrupt and non-bankrupt firms. A logistic regression model based on a set of financial variables is used as a benchmark model. Empirical results show that the resulting heavily solidity-weighted logistic model may lead to severe errors in classifying non-bankrupt firms. The present approach will avoid these kinds of error by separately evaluating the probability of the solidity and liquidity bankruptcy; the firm is not classified bankrupt as long as neither of the probabilities exceeds the critical value. This leads the present prediction method slightly to outperform the logistic model in the overall classification accuracy.