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Do Traditional Financial Distress Prediction Models Predict the Early Warning Signs of Financial Distress?

1
Management Department, University of Évora, Largo dos Colegiais, nº 2, 7000-803 Évora, Portugal
2
CEFAGE Research Center, University of Évora, 7000-812 Évora, Portugal
3
Department of Management and Economics, University of Beira Interior, Estrada do Sineiro, 6200-209 Covilhã, Portugal
*
Author to whom correspondence should be addressed.
J. Risk Financial Manag. 2019, 12(2), 55; https://doi.org/10.3390/jrfm12020055
Received: 5 February 2019 / Revised: 25 March 2019 / Accepted: 1 April 2019 / Published: 4 April 2019
(This article belongs to the Section Risk)
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PDF [303 KB, uploaded 4 April 2019]

Abstract

Purpose: This study aims to compare the prediction accuracy of traditional distress prediction models for the firms which are at an early and advanced stage of distress in an emerging market, Pakistan, during 2001–2015. Design/methodology/approach: The methodology involves constructing model scores for financially distressed and stable firms and then comparing the prediction accuracy of the models with the original position. In addition to the testing for the whole sample period, comparison of the accuracy of the distress prediction models before, during, and after the financial crisis was also done. Findings: The results indicate that the three-variable probit model has the highest overall prediction accuracy for our sample, while the Z-score model more accurately predicts insolvency for both types of firms, i.e., those that are at an early stage as well as those that are at an advanced stage of financial distress. Furthermore, the study concludes that the predictive ability of all the traditional financial distress prediction models declines during the period of the financial crisis. Originality/value: An important contribution is the widening of the definition of financially distressed firms to consider the early warning signs related to failure in dividend/bonus declaration, quotation of face value, annual general meeting, and listing fee. Further, the results suggest that there is a need to develop a model by identifying variables which will have a higher impact on the financial distress of firms operating in both developed and developing markets. View Full-Text
Keywords: financial distress; emerging market; prediction models; Z-score; logit analysis; probit model financial distress; emerging market; prediction models; Z-score; logit analysis; probit model
This is an open access article distributed under the Creative Commons Attribution License which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited (CC BY 4.0).
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Ashraf, S.; G. S. Félix, E.; Serrasqueiro, Z. Do Traditional Financial Distress Prediction Models Predict the Early Warning Signs of Financial Distress? J. Risk Financial Manag. 2019, 12, 55.

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