Analysis of a Bankruptcy for a Firm Essay Example | Topics and Well Written Essays - 1000 words

Analysis of a Bankruptcy for a Firm - Essay Example As a result of this, it becomes imperative to predict if any firm has chances of going bankrupt. Accurate forecasting of bankruptcy enables a firm to take corrective actions, and thereby reducing losses, and possibly even prevent bankruptcy. Hence, bankruptcy prediction is a topic of great interest and attracting a lot of research. There are two kinds of bankruptcy prediction models, generally found in the literature. The first is the accounting based models, which include logistic regression models. The second category is the market-based model, which include Merton Models. Fitzpatrick (1931) used the approach of using ratio analysis to compare bankrupt and successful firms. His univariate model of using 13 ratios to indicate failure was first attempt of such kind to predict industry failures. However, no significant relationship could be established between the model and failure. The work done by Beaver (1966) is considered as the first pioneering work in the field of bankruptcy prediction. He proposed that the firm can be seen as a â€Å"reservoir of liquid assets, which is supplied by inflows and drained by outflows. (†¦) The solvency of the firm can be defined in terms of the probability that the reservoir will be exhausted, at which point, the firm will be unable to pay its obligations as they mature†. Beaver used 30 ratios to develop a univariate model. These ratios were applied to 158 companies, half of them as bankrupt and the other half as successful firms. The finest ratios were the â€Å"working capital funds flow/ total assets†, and â€Å"net income/ total assets†. These ratios correctly identified 90%, and 88% of the cases. This study was followed by Altman’s model (1968, 1983). He applied multiple discriminant analysis to 33 pairs of bankrupt and successful firms. He proposed that bankruptcy could be explained by using a combination of 5 financial ratios.  Ã‚