Factors Affecting the Probability of Bankruptcy: A Managerial Decision Based Approach

The majority of classification models developed have used a pool of financial ratios combined with statistical variable selection techniques to maximize the accuracy of the classifier constructed. Rather than follow this approach, this article seeks to provide an explicit economic basis for the selection of variables for inclusion in bankruptcy models. This search to develop an economic theory of bankruptcy augments the existing bankruptcy prediction literature. Variables which occur in bankruptcy probability expressions derived from the solution of a stochastic optimizing model of firm behaviour are ‘proxied’ by variables constructed from financial statement data. The random nature of the lifetime of a single firm provides the rationale for the use of duration or hazard‐based statistical methods in the validation of the derived bankruptcy probability expressions. Results of the validation exercise confirm that the majority of variables included in the empirical hazard formulation behave in a way that is consistent with the model of the firm. The results highlight the need for developments in the measurement of earnings dispersion.