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Emerald Article: Prediction of corporate financial distress in an emerging

market: the case of Turkey
Mine Ugurlu, Hakan Aksoy

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Mine Ugurlu, Hakan Aksoy, (2006),"Prediction of corporate financial distress in an emerging market: the case of Turkey", Cross
Cultural Management: An International Journal, Vol. 13 Iss: 4 pp. 277 - 295
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Mine Ugurlu, Hakan Aksoy, (2006),"Prediction of corporate financial distress in an emerging market: the case of Turkey", Cross
Cultural Management: An International Journal, Vol. 13 Iss: 4 pp. 277 - 295
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Prediction of corporate financial Prediction of

corporate
distress in an emerging market: financial distress
the case of Turkey
Mine U

gurlu 277
Department of Management, Bog
aziçi University, Istanbul, Turkey, and
Hakan Aksoy
Bilgi University, Turkey
Abstract
Purpose – To identify predictors of corporate financial distress, using the discriminant and logit
models, in an emerging market over a period of economic turbulence and to reveal the comparative
predictive and classification accuracies of the models in this different environmental setting.
Design/methodology/approach – The research relies on a sample of 27 failed and 27 non-failed
manufacturing firms listed in the Istanbul Stock Exchange over the 1996-2003 period, which includes
a period of high economic growth (1996-1999) followed by an economic crisis period (2000-2002). The
two well-known methods, discriminant analysis and logit, are compared on the basis of a better
overall fit and a higher percentage of correct classification under changing economic conditions.
Furthermore, this research attempts to reveal the changes, if any, in the bankruptcy predictors, from
those found in the earlier studies that rested on the data from the developed markets.
Findings – The logistic regression model is found to have higher classification power and predictive
accuracy, over the four years prior to bankruptcy, than the discriminant model. In this research, the
discriminant and logit models identify the same number of significant predictors out of the total
variables analyzed, and six of these are common in both. EBITDA/total assets is the most important
predictor of financial distress in both models. The logit model identifies operating profit margin and
the proportion of trade credit within total claims ratios as the second and third most important
predictors, respectively.
Originality/value – This paper reveals the accuracy with which the discriminant and logit models
work in an emerging market over a period when firms face high uncertainty and turbulence. This study
may be extended to other emerging markets to eliminate the limitation of the small sample size in this
study and to further validate the use of these models in the developing countries. This can serve to
make the methods important decision tools for managers and investors in these volatile markets.
Keywords Financial performance, Predictive process, Modelling, Turkey
Paper type Research paper

1. Introduction
The prediction of financial distress has been a field of study during the last 70 years.
The early researches (Ramser and Foster, 1931; Fitzpatrick, 1932; Winakor and Smith,
1935; Merwin, 1942) focused on the comparison of the values of financial ratios in failed
and non-failed firms and concluded that the ratios of the failed firms were poorer.
The pioneering study of Beaver (1966) presented the univariate approach of the
discriminant analysis which was expanded into a multivariate framework by Altman
(1968). The discriminant analysis has been the primary method of failure prediction
until 1980s during which the use of logistic regression method was emphasized.
In recent years, artificial neural networks have produced promising results in
prediction of the financial distress. Cross Cultural Management: An
The aim of this paper is twofold. First, it attempts to search for predictors of International Journal
Vol. 13 No. 4, 2006
financial distress that lead to the highest classification rates for corporations in an pp. 277-295
emerging market over a period of economic turbulence. Second, it searches for the # Emerald Group Publishing Limited
1352-7606
statistical method that leads to the highest prediction accuracy, by re-examining the DOI 10.1108/13527600610713396
CCM discriminant and logistic regression methods, in a highly unpredictable economic
environment.
13,4 The economic crisis that started in February of 2001, with the collapse of the
banking system in Turkey, had its adverse repercussions on the capital market.
The downturn of the capital market and the shooting interest rates coupled with the
substantial devaluation of the Turkish lira against other currencies had severe impacts
on the corporations leading several firms to bankruptcy. The study covers the period of
278 a deeply effective crisis and aims to contribute to the identification of critical variables
that lead to corporate financial distress in turbulent environments.
This study covers 27 manufacturing firms that faced financial failure during the
1996-2003 period and their non-failed mates of similar size from the same industry.
The distressed firms represent 84 per cent of the population over the period of analysis
due to the elimination of five companies that had missing data in some years. The firms
in the sample are manufacturing firms that are in the lowest quartile of market value in
the capital market. So, both the failed and non-failed firms in the sample are small in
size, as measured by their market values, relative to the rest of the publicly traded
firms in the capital market. Almost half of the distressed firms are from the textiles
industry. Most of the corporate failures have occurred after the economic crisis which
implies that economic downturns and the industry characteristics seem to emphasize
the impact of incorrect policies adopted by the corporations.
The findings of this study document that the logistic regression model provides a
better overall fit and higher predictive accuracy than the discriminant model. The
predictive power of the discriminant model in the first year prior to bankruptcy is lower
than those documented by previous studies. This results from the violation of the
assumptions of the discriminant method, multivariate normality of independent variables
and equal dispersion of variance–covariance matrices across the groups, in this study.
Both methods identify higher number of significant predictors than those revealed
by some studies in this field. Out of the 11 predictors of distress identified by the logit
model and ten variables selected by the discriminant model, six are common in both
models. EBITDA/ total assets, EBIT/sales, fixed asset turnover, return on equity, size,
and tax burden are the variables selected by both models.
Firm size reveals a positive relation with financial distress in both models. The
financially distressed firms are relatively larger in size and use higher leverage than the
non-distressed firms.
The logit model identifies 11 significant predictors, which are indicators of the
degree of economic distress, solvency, liquidity, trade creditors’ coordination, return on
equity, tax burden, and size. EBITDA/ total assets ratio is the most important predictor
in bankruptcy prediction. The negative sign of its coefficient reveals that an increase in
the earning power of assets, abstracting from any leverage and tax factors, causes the
likelihood of financial distress to decrease. EBIT/sales is the second most important
predictor in the logit model.
The ratio of trade credit to total claims is positively related with the probability of
financial distress and is found to be the third most important predictor of failure
following the economic distress variables.
The signs of the coefficients of some significant predictors have been contrary to
expectations and have contributed to revealing the underlying problems of the
economic system. The high rate of inflation and the attractive real returns on financial
securities have resulted in a reduction in the level of capital investments and operating
profits. The economic downturn seems to have adversely affected the corporations that
had relatively higher short-term liabilities and lower operating profitability. The Prediction of
variables selected by the logit model imply that heavy short-term financing and capital
insufficiency, due to low operating profitability or consecutive losses leading to equity
corporate
deterioration, are the major determinants of corporate financial distress. financial distress
The second section of this paper documents the evidence presented in finance
literature. The research design section includes the sample selection process, data
collection, and the measurement of the variables with a detailed explanation of the
methodology used. The findings of the study are documented in the results section.
279
An integrative assessment of the findings is presented in the conclusion.

2. Theoretical overview
The use of financial ratios in discrimination of failing and non-failing firms started in
1930s. The studies in this group (Winakor and Smith, 1935; Ramser and Foster, 1931;
Merwin, 1942; Hickman, 1958) concluded that failing firms exhibit significantly
different ratio measurements than continuing entities.
The change in research took place when Beaver (1966) presented the univariate
analysis, which set the stage for the multivariate attempts that followed. Beaver’s
study documented that failure status of firms can be correctly predicted to a much
greater extent than would be expected from random prediction. This suggested that
financial ratios could be useful in the prediction of failure for at least five years prior to
failure. Beaver (1968a) extended his earlier work to examine the differences in the
predictive ability of the ratios indicating that non-liquid asset measures predict failure
better than the liquid asset measures and that there are also differences in the
predictive power of ratios among the liquid asset measures.
A pioneering study in the field is done by Altman (1968) who employed multiple
discriminant analysis (MDA) to classify financial ratios and developed a bankruptcy
prediction model. The discriminant ratio model proved that bankruptcy could be
accurately predicted up to two years prior to actual failure with the accuracy
diminishing rapidly after the second year. This research is followed by a number of
studies that have used MDA (Deakin, 1972; Edminster, 1972; Blum, 1974; Beaver,
1968a; 1968b; Altman, 1973; Altman and Lorris, 1976; Altman and McGough, 1974;
Altman et al., 1977; Libby, 1975; Moyer, 1977; Sharmaand and Mahajan, 1980; Taffler
and Tisshaw, 1977). Altman et al., (1977) reworked the Z-score model including a
number of refinements in the utilization of MDA as well as in the computation of
financial ratios to incorporate the effects of the changes in size and financial profile of
business failures, changes in the financial reporting standards and the advances and
controversial aspects of discriminant analysis ( Joy and Tollefson, 1995; Altman and
Eisenbeis, 1976). The ZETA model is more accurate in bankruptcy classification in
years two-five compared to the original Z-score model. These studies reveal a potential
of ratios as predictors of bankruptcy.
Subsequent attempts are made to compare the predictive power of ratios and stock
returns. Beaver (1968b) compared the predictive power of capital market derived data
and financial ratios and concluded that ratios have a superior discriminating power.
In a similar study, Aharony et al., (1980) document a sharp decline in the differential
return during the seven weeks prior to bankruptcy and conclude that even shortly
before the event, the market did not fully expect that these firms would soon file for
bankruptcy. The variance of the mean returns for the distressed firms is significantly
attributable to the firm specific variables like production, investment, and leverage and
not to market wide factors concluding that beta is not a useful indicator of firm
CCM deterioration over time. This finding is in line with Levy (1978) who documents that, in
13,4 an imperfect market, beta plays no role in price determination and that variance
provides a better explanation for price behavior.
Until 1980s, MDA has been the dominant method in failure prediction. However, it
suffered from the assumptions that were violated very often (Ohlson, 1980). During the
1980s, the discriminant method was replaced by logistic analysis, which until last
years have been the most used statistical method for failure prediction (Ohlson, 1980;
280 Back, et al., 1996). During the 1990s, artificial neural networks produced promising
results in bankruptcy prediction (Wilson and Sharda, 1995; Serrano Sinca et al., 1993;
Back et al., 1994; 1996).
In a comparative study of the discriminant, logit, and genetic algorithm models,
Back et al., (1996) document the differences in the selection of independent variables
and in failure prediction accuracy. They reveal that the use of the three methods leads
to different prediction models. The amount of variables included in the models varies
and different methods lead to the selection of different financial ratios. Despite the
selection method used, liquidity seems to be very important factor in failure prediction
and the stepwise selection for the logit model uses the fewest number of factors in all
three years prior to failure
A comparative analysis of the credit risk models developed in recent years (Crouhy
et al., 2000) documents that these models relate the probability of default to the market
value of the firm’s assets which in turn depend on the shape of the economy.

3. Research design
3.1. The sample
The sample consists of 27 failed and 27 non-failed manufacturing firms. Stratified
random sampling is used and each failed firm is matched with a non-failed firm of
similar size in the same industry. Distressed firms in the sample include those that
faced financial difficulties over the 1996-2003 period, covering the first quarter of 2003
only. The population of financially distressed manufacturing firms in the Istanbul
Stock Exchange (ISE) over this period is 32. Five of the firms were eliminated because
of missing data in some years, and the number of financially distressed manufacturing
firms, which submitted their statements regularly over this period, is reduced to 27.
Since the study is confined to manufacturing firms only, the sample represents
84 per cent of the population of the financially distressed manufacturing firms over the
research period.
The firms in financial distress are those that have been withheld from listing in the
ISE either temporarily or permanently for the reasons declared in the below mentioned
parts of Article 16 of the ISE listing regulation and Article 324 of Turkish Commercial
Law. These include the following states:
(1) Accumulated losses exceed shareholders’ equity (16/b).
(2) The firm is forced into liquidation (16/f ).
(3) The corporation has difficulty in repayment of its financial obligations, has
financing problems, or has filed for bankruptcy (16/h).
(4) The corporation has used up 2/3 of its shareholders’ equity. (As defined in
Turkish Commercial Law, Article 324).
(5) The company faces difficulty in retirement of its outstanding bonds, payments
of interest and/or principal on its financial debt obligations (16/ö).
The firms in the sample are selected from those that have been listed in the ISE because Prediction of
of the difficulty in having access to the financial statements of the private firms whose corporate
stocks are not publicly traded. The research is based on the 1996-2003 period because
the financial statements of the firms in the ISE are standardized in 1996 and a research
financial distress
based on the previous years’ statements could be susceptible to errors that would stem
from misclassification of some accounts.
The sample is stratified with respect to two digit SIC codes for industries. The 281
limited size of the sample restrains further classification. The industry classification of
the sample is presented in Table AI in the Appendix. Nearly half of the distressed firms
in the sample are from textiles industry. The rest are from food and beverage, basic
metal, metal products, chemicals and plastic products, industry based on stone and
sand, and paper and paper products industries.
In most of the previous studies, total assets or sales values one year prior to
bankruptcy are used as size proxies. However, matching firms on the basis of sales and
asset values did not reveal meaningful results in this study. This may arise from the
way default date is defined in this research. The date of default is the date at which
the firm is disqualified for listing in the ISE, as announced by the board of directors,
due to existence of one or more conditions listed before. However, financial distress
may have started long before and the firms may have been allowed to take
precautionary actions to improve their financial positions while trading in the capital
market. Sales and asset values may have deteriorated long before the decision of the
board, making it difficult to match the firms on the basis of asset or sales values one
year prior to failure.
In this study, market capitalization value is used to classify the firms into size
groups. Firms are ranked from the highest market capitalization value to the lowest
based on average monthly values of 227 manufacturing firms listed in the ISE in 1999.
This is selected as the base year because it was a period of high economic activity that
was followed by an economic crises that first signaled in November of 2000 and was
deeply effective in February of 2001. The crises started with the collapse of the banking
system and takeover of many private commercial banks by the Turkish government
transferring their control to the Savings Deposit Insurance Fund. Some of the banks
continued operations by improving their equity, some were liquidated, and some were
restructured through mergers. Some of the financially distressed firms in the sample
were affiliates of these commercial banks and their market values were adversely
affected. Consequently, the sample classification with respect to size is based on 1999
values to eliminate the adverse effects of the economic crisis on firm values. The
cumulative market capitalization is divided into four quartiles, the fourth quartile
including the firms that have the lowest market values. All the financially distressed
firms in the sample (Group 1) and matching non-distressed firms (Group 0) are in the
fourth quartile, and there is no significant difference in size between the groups at
95 per cent confidence level.
The default years of the firms in the sample differ but majority of the firms
(88.9 per cent) faced distress during 2001-2003 period. Some of the distressed firms
have been liquidated, but most are undergoing a restructuring process or merger. One
of the financially distressed firms has totally changed its field of operations form
textiles to beverages and alcoholic drinks and has applied to the Securities Exchange
Commission to qualify for listing in the ISE.
CCM 3.2. Data collection
The data of this study is derived from the year-end balance sheets and income
13,4 statements of the firms in the sample during 1996-2002 period. The financial
statements are adjusted for inflation using 1996 as the base year.

3.3. Variables
The field of research on bankruptcy prediction has revealed a large number of
282 significant predictors of failure (Beaver, 1968a; Blum, 1974; Altman, 1968; Altman, et al.,
1977; Chatterjee et al., 1966; Back et al., 1996). In this study, a comprehensive list of 80
financial ratios is developed at the initial stage. These variables are grouped into eight
categories including profitability, liquidity, solvency, degree of economic distress,
leverage, efficiency, variability, and size. Factor analysis is conducted to identify the
variables that seem to be doing the best job in predicting financial distress.
Consequently, 22 variables are identified by stepwise selection and are used in
subsequent analyses to reveal those that are significant predictors of failure. The list
and measurement of the selected variables are presented in Table AII in the Appendix.
The summary statistics of the variables are presented in Table I.
The variables used in the analyses reflect average values, for the period of analysis,
for each firm depending on how many periods it has existed in the ISE. Since the
failure dates of the firms differ, the number of observations for each firm is different.
However, the measurement for each firm utilizes data one year-end financial statement
prior to bankruptcy. So, the leading time differs for each firm ranging between three
months and nine months before failure.

Non-failed firms Failed firms Total

(N ¼ 122) (N ¼ 88) (N ¼ 180)
Standard Standard Standard
Variable Mean deviation Mean deviation Mean deviation F Sig.

TOAS 12.402 13.816 17.202 13.707 13.948 13.925 4.768 0.030*

CATA 0.643 0.148 0.642 0.208 0.643 0.169 0.000 0.983
SETA 0.387 0.198 0.154 0.245 0.312 0.239 0.793 0.000**
APNPTA 0.122 8.306 0.172 0.107 0.138 9.426 11.793 0.001**
SCA 0.561 0.204 0.506 0.573 0.544 0.365 0.892 0.346
SWC 1.814 2.691 6.590 33.986 3.352 19.435 2.393 0.124
STFA 1.343 0.723 3.344 5.543 1.988 3.319 15.438 0.000**
QAS 1.221 0.503 1.887 1.657 1.436 1.069 16.561 0.000**
GPM 0.303 0.185 0.266 0.136 0.291 0.172 1.877 0.172
QAI 2.802 5.106 3.167 4.107 2.919 4.798 0.227 0.634
LTDTD 0.272 0.164 0.209 0.148 0.252 0.161 6.053 0.015**
WCLTD 2.386 3.995
1.358 9.769 1.179 6.653 13.306 0.000**
MVETL 0.582 0.757 0.294 0.341 0.489 0.665 7.621 0.006**
CASH 5.651 0.107 0.185 0.248 0.144 0.221 14.295 0.000**
FEFL 0.714 3.731 0.142 0.073 0.529 3.079 1.358 0.245
FASE
0.004 11.139 2.751 10.157 0.884 10.882 2.541 0.113
ROE 0.271 1.842
0.079 0.716 0.159 1.576 1.949 0.164
EBITPC 0.494 0.588 1.112 2.265 0.693 1.397 8.013 0.005**
EBITS 0.145 0.165 0.214 0.283 0.167 0.212 4.320 0.039*
EBITDT 0.074 4.292 0.057 4.205 0.069 0.043 6.540 0.011**
OIBOIA 0.976 9.132 46.690 347.58 16.029 197.50 2.214 0.138
Table I. VOL 0.981 0.246 1.038 0.187 0.999 0.229 2.418 0.122
3.4. Methodology Prediction of
Factor analysis is used to identify the most important predictors to be used in corporate
subsequent analyses. The selected variables are used in discriminant analysis to
develop a model for failure prediction. A further study is conducted using logistic financial distress
regression and a comparative analysis of the predictive models is documented.
Factor analysis rests on the quarterly financial statements of the firms. The number
of observations per variable is ten, which is above the minimum ratio of five 283
observations per variable. The variables are selected so as to have a minimum of 0.55
loading. The observations that are +/
3 standard deviations from the mean are
regarded as outliers and are eliminated. The factors are labeled and the variable that
has the highest loading on each factor is selected. The analysis reveals that 22
variables that are selected explain 76.76 per cent of the variance and the addition of one
more variable contributes to explained variance by less than 1.25 per cent.
The discriminant analysis rests on the data generated from the year-end financial
statements of the firms and is carried out to identify the most important predictors in
bankruptcy classification using the variables identified by the factor analysis. Nine
observations per variable are obtained, satisfying the criterion of minimum five
observations per variable. The stepwise procedure is used and a significance criterion
of 5 per cent or less is utilized. The stepwise selection identifies ten variables as
significant predictors. The discriminant analysis is found to be highly significant and
yields a correct classification rate of 85.9 per cent, which is above the minimum chance
criterion of 66.25 per cent in this case. However, Box’s test of equality of covariance
matrices has lower significance than the critical level of 0.01 ( p ¼ 0.00), revealing that
the assumption of identical variance–covariance across groups is violated. Since the
number of observations in the two groups are unequal, the violation of the normality
assumption weakens the prediction power of the model further.
Consequently, logistic regression is used to develop a model for failure prediction.
The variables are identified through stepwise selection procedure. There is no
multicollinearity among the independent variables since they are selected using factor
analysis and VIF values around one confirm this. The logistic regression model reveals
11 significant variables as predictors of failure. Six of the variables are selected by both
methods. Tests of statistical significance and overall model fit for the logistic
regression model, as summarized in Table II, reveal that it is a better method to be used
when normality assumption is violated. The correct classification rate of this model is
97.5 per cent for the non-failed group and 91.4 per cent for the failed group. The overall
percentage of correct classification is 95.6 per cent, which is above the correct
classification power of the discriminant analysis.

Value Value Sig.

2 Log Likelihood (
2LL) 50.159 From base model 176.550 0.00

Cox and Snell R2 0.624 From prior step 12.482 0.00
Nagelkerke R2 0.872
‘‘Pseudo’’ R2 0.175 Table II.
Chi-square df. Sig. Overall model fit tests
Hosmer and Levishow 10.106 8 0.258 of the logit model
CCM 3.5. Validation and predictive accuracy
Validation of the function by the use of a holdout sample is not possible due to the lack of
13,4 a new set of financially distressed firms with publicly available data over the research
period and the limited sample size of this study. Therefore, a compromise procedure is
selected by developing the function on the entire sample and then using the function to
classify the same group used to develop the function. This procedure results in an
upward bias in the predictive accuracy of the function (Hair et al., 1998, p. 259).
284 In assessment of predictive accuracy of the models in this study, classification matrices
are developed; cutting scores are determined for each year prior to bankruptcy and
compared with proportional chance criteria shown later. However, chance model criteria
are more useful when computed with holdout samples and predictive accuracy will be
biased upward if the firms used in calculating the function are the ones being classified.
The criterion of classification accuracy to be at least one-fourth greater than that
achieved by chance (Hair et al., 1998, p. 269) is satisfied by both models. The Press’s
Q Statistic is estimated for each year prior to bankruptcy and results are above the
critical value at a significance level of 1 per cent for each year in both models.

4. Results
4.1. Logistic regression
The logistic regression model has a better overall fit and a higher percentage of bankruptcy
classification than the discriminant model. The method identifies 11 variables as important
predictors of failure. Nine of these variables are significant at 1 per cent level and two are
significant at 5 per cent level. The Hosmer and Levishow (1989) measure of overall fit and
chi-square test for the change in
2LL value from the base model are used as tests of
statistical significance and presented in Table II along with other tests of overall fit.
The insignificant chi-square in the Hosmer and Levishow test indicates that there is
no difference in the distribution of the actual and predicted dependent values. A good
model fit is indicated by a insignificant chi-square value. The reduction in
2LL is
highly significant and smaller values of the
2LL measure indicate better model fit.
High R2 values for Nagelgerke and Cox and Snell tests also support the above findings
and reveal that the logistic regression model is a good fit.
4.1.1. Variables. The logistic regression model identifies 11 variables as predictors
of financial distress through stepwise selection process. The variables in the equation
are summarized in Table III.

Variable Beta SE Wald Significance Exp (B)

Constant
1.276 1.184 1.161 0.281 279

EBITDT
87.678 13.541 7.727 0.005 0.000
EBITS 18.356 6.708 7.488 0.006 9.4E þ 07
APNPT 14.798 5.916 6.256 0.012 2670830
SCA
9.603 3.024 10.085 0.001 0.000
MVETL
5.946 1.795 10.969 0.001 0.003
STFA 3.625 0.909 15.922 0.000 37.536
ROE
1.618 0.423 14.644 0.000 0.198
WCLTD
1.396 0.371 14.142 0.000 0.247
Table III. OIBOIA 0.183 0.094 3.795 0.050 1.201
Variables in the logit TOAS 0.132 0.000 11.661 0.001 1.000
model SWC 0.093 0.044 4.477 0.034 1.097
EBITDT (EBITDA/total assets) is a variable indicating the level of economic distress Prediction of
(Chatterjee et al., 1966; Hotchkiss, 1995) abstracting from any leverage or tax factors. corporate
Insolvency occurs when the value of total liabilities exceed the value of total assets
which in turn is determined by the earning power of the assets. The mean of this financial distress
variable is significantly higher for the non-failed firms and its coefficient has a negative
sign. This variable is selected as the most important predictor in both models and
preserves its negative sign. The earnings before interest, depreciation, and 285
amortization is higher in the non-failed firms since these firms use modern equipment
most of which is not highly depreciated and invest more in intangible assets with
higher amortization charges. Therefore, as EBITDT decreases, the probability of
facing financial distress increases.
Another indicator of the level of economic distress as documented by Chatterjee
et al. (1966) and Hotchkiss (1995) is EBITS measured as EBIT/sales. Chatterjee et al.
(1966) have found that firms with higher EBITDT and EBITS tend to proceed with
workouts and prepackaged bankruptcies compared to those with lower ratios filing
for bankruptcy. Although these variables are positively correlated, coefficient of
EBITS has a positive sign and the mean of the ratio is significantly higher for the failed
firms than for their counterparts in this study. Further analysis of the gross
margin ratios of the firms in the sample shows that mean of this ratio is higher for the
non-failed firms, indicating that failed firms have higher costs of production and/or
lower levels of sales, but the difference is insignificant ( p ¼ 0.172). Opler and Titman
(1994) reveal that firms with higher leverage experience output contractions leading
sales to decline by 26 per cent more than the firms that use lower leverage and a similar
decline is observed in the market value of equity concluding that the indirect costs of
financial distress are significant and positive. The authors note that the observed
losses in sales are partially customer driven and competitor driven rather than being
driven by cost cutting managers optimally downsizing in declining industries. The
higher values of EBITS for the failed firms may indicate that these firms have lower
sales and/or lower operating expenses so that the operating profit generated per dollar
of sales is higher. So, the failed firms may have invested less in development of their
sales force, promotion campaigns, or research and development programs that would
increase the competitive power of the company in the long run or have started
downsizing by adopting lower levels of recruitment to reduce general and
administrative expenses in the face of sales declines due to customer or competitor
pressures.
APNPTA (Accounts payable þ notes payable/total assets) is a proxy for creditors’
coordination (Chatterjee et al., 1966) and identifies the number of trade creditors. Trade
creditors are the most difficult group to negotiate with and tend to exert pressure over
firms under financial distress. As the proportion of trade credit to total assets
increases, the likelihood of corporate failure increases. The mean of this ratio is
significantly higher in the group of financially distressed firms than the mean of the
other group. In Turkey, trade credit is an important source of financing for the firms
since heavy reliance on short-term bank loans exhausts the debt capacity of many
firms. The extensive use of trade credit and short-term bank loans as financing sources
causes the current liabilities of the firms to increase leading to low liquidity levels and
higher risk of default.
SCA (Sales/current assets) reflects the sales generating power of the company with
its current assets. The non-failed firms have higher current asset turnover than failed
CCM firms but the difference is not significant. However, the variable becomes a significant
predictor in a multivariate framework.
13,4 MVETL (Market value of equity/book value of total liabilities) is a measure of long-
term liquidity as well as solvency. It shows by how much the firm’s assets can decline
in value before liabilities can exceed the assets and the firm becomes insolvent. The
negative sign of the coefficient is as expected. The mean of this ratio is significantly
higher (58.2 per cent) for the non-failed group than that of the failed firms (29.4 per cent).
286 Thus, the financially distressed firms face higher drops in market value as documented
by Opler and Titman (1994).
The second important variable is STFA (Sales/BV of net tangible fixed assets),
which reflects the sales generating ability of a firm’s tangible fixed assets. Generally,
the higher the ratio the more efficient is the utilization of fixed assets of the firm. The
mean of the ratio is significantly higher for the failed firms implying that these firms
have low investment in fixed assets and/or are using highly depreciated assets.
ROE (Net income/equity) and WCLTD have negative coefficients. WCLTD (Net
working capital/long-term debt) is a measure of liquidity and shows the net liquid
assets of the firm in proportion to its long-term debt. As these ratios decrease, the
probability of failure increases.
OIBOIA (Other income before taxes/other income after taxes) is used to assess the
tax burden of the company. Most of the firms in Turkey report low operating income
but high taxable income because the firms generate income mainly from investments in
Treasury bonds or other marketable securities. The mean of the variable is much larger
for the failed group but the standard deviation is also very high and the difference is
insignificant. It seems that the firms in the failed group have higher tax burden
generated from non-operating income than the non-failed firms. However, the value of
its coefficient and the significance level are lower than most of the predictors in the
model.
TOAS ((Total assets/1000)/WPI) is a proxy of size and reflects the total asset values
divided by the wholesale price index (1994 ¼ 100). This adjustment in asset values
eliminates the adverse effects of two-digit inflation in Turkey on assets that are
recorded at historical costs. Interestingly, the financially distressed firms are
significantly larger, in terms of asset values, than the firms in the other group
supporting Altman et al., (1977). This variable has been selected as a significant
predictor of failure in discriminant and logit analyses but its coefficient is small relative
to other predictors in both models indicating that size has relatively weaker effect in
prediction of financial distress in a multivariate framework. This result supports the
previous finding that size is positively related with leverage (U
gurlu, 2000) and might
indicate that firms adopt sub-optimal growth strategies and/or finance growth with
leverage when the profitability is insufficient to cover the costs of debt which will
reduce the firm value and raise the risk of bankruptcy.
SWC (Sales/net working capital) is a measure of liquidity (Sharmaand and
Mahajan, 1980). The mean working capital turnover is higher for the failed firms than
non-failed firms, but the difference is not significant and the standard deviation is very
high in the failed group. The coefficient of the ratio is positive. Increase in
working capital turnover generally implies high efficiency in the utilization of assets.
However, the failed firms rely mostly on short-term bank loans and trade credit for
financing as APNPTA and LTDTD ratios indicate. Therefore, the current liabilities of
these firms are high. Moreover, a firm that experiences losses may have shrinking
current assets relative to total assets. These factors cause the net working capital of the
financially distressed firms to decline and severe liquidity problems to arise. Prediction of
Consequently, increase in net working capital turnover may result from insufficient net corporate
working capital levels and documents a positive relation with the likelihood of firm
failure. financial distress
4.1.2. Classification power. The average percentage of firms correctly classified
in logit analysis is 95.6 per cent. The per cent of correct classification for the non-
failed firms is 97.5 per cent whereas the correct classification for the failed firms is
91.4 per cent. Three cases out of 122 in the non-failed group are recorded as failed
287
(Type II error) and five cases out of 58 cases in the failed firms group are classified as
non-failed (Type I error). The classification matrix is presented in Table IV.
A comparative analysis of the models, with respect to classification errors,
reveals that using logistic regression model reduces both types of errors substantially
(Table V).
4.1.3. Predictive accuracy. The predictive accuracy of the logistic regression is
presented in Table VI.
The predictive accuracy of the logistic regression model is higher than the
discriminant in all the years prior to failure. It is 94.5 per cent one year prior to failure
and decreases slowly becoming 94.3, 91, and 87.1 per cent in years two, three, and
four prior to bankruptcy, respectively. The predictive accuracy of the non-failed
firms is substantially higher than the failed firms in all years prior to bankruptcy as
revealed in Table VI. This results from higher number of observations in the non-failed
group.
A comparative assessment of the prediction power of the logit and discriminant
models, Cpro values and Z values are presented in Table VII.
4.1.4. Type I and type II errors. There are different penalty costs for each type of
error. Type I error is more important for a creditor who would lend to a failed firm

Predicted membership
Original Non-failed Failed Total
Table IV.
Non-failed 119 (97.5%) 3 (2.5%) 122 Classification matrix of
Failed 5 (8.6%) 53 (91.4%) 58 the logit model

Discriminant (%) Logit (%)

Table V.
Type I error 18.2 8.6 Errors of the prediction
Type II error 11.6 2.5 models

Years prior to failure

1 2 3 4

Failed 89.6% (N ¼ 58) 88.6% (N ¼ 35) 81.8% (N ¼ 22) 70.0% (N ¼ 10) Table VI.
Non-failed 96.9% (N ¼ 97) 97.2% (N ¼ 71) 95.6% (N ¼ 45) 95.2% (N ¼ 21) Predictive accuracy of
Total 94.5% (N ¼ 145) 94.3% (N ¼ 106) 91.0% (N ¼ 67) 87.1% (N ¼ 31) the logit model
 13,4

288
CCM

Table VII.

predictive accuracy
Comparative analysis of
Discriminant analysis Logistic regression
Predict. Number Cpro Z Predict. Number Cpro Z
power (%) of data (%) value p value (%) power (%) of data (%) value p value (%)

Model 85.9 206 53.2 13.51 0.00 95.6 180 56.3 25.54 0.00
One year 84.0 169 52.4 11.22 0.00 94.5 145 55.7 20.45 0.00
Two year 81.3 123 52.8 8.11 0.00 94.3 106 55.8 17.19 0.00
Three year 77.5 80 52.5 5.35 0.00 91.0 67 55.9 10.08 0.00
Four year 73.5 34 58.5 1.99 2.33 87.1 31 56.3 5.12 0.00
considering it non-failed. Type II error may lead the creditor not to lend to a firm Prediction of
considering it as a high risk investment and causing a loss of return that would corporate
otherwise be generated. Type I errors of the logit model are higher than type II errors in
all years prior to failure. Type I and type II errors of the logit model are presented in financial distress
Table VIII.
A comparative analysis of the errors reported in this study over the three-year
period prior to bankruptcy with those of Back et al., (1996) is presented in Table A III in
the Appendix. The total error of the logit model developed in this study is substantially
289
lower than presented by Back et al., (1996) findings in all years prior to failure. This
model has significantly lower type II errors in all the years prior to failure than the
predictive results reported by the same study. However, type I error is slightly higher in
the third-year prior to bankruptcy. A comparison of the findings of this study with the
evidence existing in finance literature may need caution because the small sample size
of this study prevents cross validation, and the lack of a new sample of financially
distressed firms causes an upward bias in assessment of the validation of predictive
accuracy of the models. Furthermore, the differences in the time periods covered, type
of industry included, and the definition of the period prior to bankruptcy, which result
in different lead times, may affect the comparative assessment of the predictive
accuracy of the models.

4.2. The Z-score function

Findings related to the discriminant model are summarized to enable a comparative
assessment of the models with respect to the selection of the significant predictors of
failure.
The discriminant analysis is highly significant (chi-square ¼ 117.62, p ¼ 0.000)
and explains 49.3 per cent of the variance in the dependent variable. The stepwise
analysis identified ten variables all of which are significant below 0.001. The Z-score
function reveals ten significant variables six of which are also selected by the logit
model.
The means of ROE, OIBOIA, and FASE ratios do not reveal significant differences
among the two groups but become significant predictors of distress in the Z-score
function shown below.

Z ¼ 1:054
13:613EBITDT
3:518SETA þ 2:742EBITS
1:609LTDTD

þ 0:248EBITPC
0:172ROE þ 0:20FASE þ 0:131STFA ð1Þ
þ 0:035TOAS þ 0:001OIBOIA

SETA (BV of equity/BV of total assets) has the highest loading with the function and
seems to be the second most important variable in the discriminant model. The mean

Years prior to failure

1 2 3 4

Type I error 10.4% 11.4% 18.2% 30%

Type II error 3.1% 2.8% 4.4% 4.8% Table VIII.
Total error 5.5% 5.7% 9.0% 12.9% Type I and type II
N 145 106 67 31 errors in the logit model
CCM of the variable is significantly higher for the non-failed group and its negative sign is
13,4 as expected. As leverage increases, SETA drops and the probability of total
liabilities to exceed the total assets increases causing the likelihood of financial distress
to rise. SETA is a measure of solvency used in previous researches (Ravid and
Sundgren, 1998; Sharmaand and Mahajan, 1980). Firms in financial distress
report losses for consecutive periods, which reduce equity values and SETA ratio.
290 More leveraged firms have lower rates of investment growth and higher asset
sales than the firms using lower leverage. As Myers (1977) argues, financial slack
is an important determinant of investment expenditures. Furthermore, as firms suffer
losses and deteriorate toward failure, their assets are not replaced as much as in
healthier firms (Altman, 1968). This variable is replaced by MVETL ratio in the logit
model.
In addition to SETA, the proportion of long-term debt in total debt (LTDTD), return
on paid capital (EBITPC), and the ratio of fixed assets to equity (FASE) are the
variables that are selected as significant predictors by the discriminant model but are
replaced by other variables in the logit model.
The mean of EBITPC (EBIT/paid capital) is significantly higher for the failed
firms than for the non-failed firms. Most of the firms that face financial distress
have insufficient equity investment. Since this ratio eliminates the legal reserves,
revaluation fund, and net profit that exists in shareholders’ equity and concentrates
only the amount of capital invested by shareholders, it reflects the small amount of
equity capital injection in the failed firms. A small portion of the equity of the
firms trading in the ISE is publicly owned and the ownership structure of these
companies is highly concentrated (U
gurlu, 2000) leading to low amounts of paid
capital. The positive relation with the discriminant function indicates that an increase
in the return on invested capital raises the likelihood of bankruptcy because of capital
insufficiency.
LTDTD (Long-term debt/total debt) reflects the proportion of long-term debt in
total debt. Non-failed firms use significantly higher amount of long-term debt than
the failed firms. The mean LTDTD of 20.9 per cent for the failed firms indicates that
these firms use short-term debt intensively. Low equity levels coupled with heavy
reliance on short-term debt in failed firms indicate severe liquidity problems that
increase the risk of default. Therefore, an increase in LTDTD reduces the probability of
failure.
FASE (BV of fixed assets/BV of equity) is used as an indicator of financial structure.
As FASE increases, the percentage of fixed assets financed by equity decreases and the
probability of failure rises.

5. Conclusion
This paper attempts to examine the well-known models of bankruptcy prediction, the
discriminant and logistic regression methods, in an emerging market over a period of
high economic turbulence in contrast to the evidence prevailing for the corporations of
the developed economies. Predictive power of the models is evaluated and the critical
predictors of financial distress are identified with an emphasis on the differences of the
results obtained in this study relative to others.
The evidence reveals that the logistic regression method reveals a better overall fit
and yields an average correct classification of 95.6 per cent. The model correctly
classifies 97.5 per cent of the non-failed firms and 91.4 per cent of the failed firms.
 Logistic regression model has higher predictive accuracy than the discriminant Prediction of
model in all years prior to bankruptcy. Predictive results of the logit model are 94.5,
94.3, 91, and 87.1 per cent in years one, two, three, and four prior to bankruptcy,
corporate
respectively. Type II errors detected in the logit model are significantly lower than type I financial distress
errors over the four years prior to bankruptcy.
The findings document the outstanding impact of the earning power of assets,
operating profit margin, and the composition of liabilities on corporate failure. This
evidence supports the tendency of most of the distressed firms in the sample to arrange
291
workouts, rather than filing for bankruptcy, to resolve the problem of low operating
returns relative to investments and to coordinate the high number of trade creditors
through reorganization processes.
The signs of the coefficients of some predictors that have been contrary to
expectations reflect the distortions in the corporate financial structures, revealing the
impact of the constraints of the financial system surrounding the corporations. The
extensive use of trade credit and short-term bank loans relative to long-term debt and
equity financing reduces the level of net working capital and increases the risk of
default. Access to the capital market funds may be costly especially under financial
distress. Furthermore, the corporate bond market is inactive because of the high
interest rates on T-Bills and T-Bonds. The lack of long-term funds results in lower
levels of fixed asset investments and the use of highly depreciated fixed assets.
Consequently, higher values of fixed asset turnover and working capital turnover for
the failed firms do not indicate increased efficiency in the utilization of assets but
signal low levels of net working capital and fixed asset investments. The positive sign
of the coefficients of EBIT/sales and the fixed asset turnover ratios indicate that the
failed firms have lower investment in fixed assets and face higher sales contractions in
recessionary periods. As firms suffer losses and deteriorate toward failure, asset
replacement declines leading to higher turnover ratios that in turn indicate that there is
insufficient capital to support sales. Furthermore, slower employment growth for the
distressed firms results in the reduction of operating costs and sales when managers
try to downsize efficiently during industry downturns.
The negative coefficients of current asset turnover, capitalization, return on
equity, and liquidity, ratios are as expected. Net working capital seems to be more
important in predicting financial distress than current assets because it indicates the
impact of the high level of current liabilities, in financially distressed firms, relative to
the current asset investments. Capital market based ratios such as returns to
shareholders and the variability of returns are not significant predictors of financial
distress in the models developed.
The findings of this research indicate that profitability, liquidity, and solvency ratios
are major predictors of failure. The evidence reveals that firms should focus on
increasing operating profits, and the level of net working capital while shifting to long-
term sources of finance to support investments.
Both methods reveal that firm size, as measured by total assets of the firms, is
significantly larger in the failed group than the non-failed group. Although the
significant, positive relation between firm size and probability of failure is not very
strong, this finding may indicate that the firms tend to adopt sub-optimal growth
strategies and/or finance growth with debt when the cost of funds exceeds the
profitability. The economic crisis have increased the costs of leverage above the
predicted levels and have further increased the risk of bankruptcy for the growing
firms. Since most of the firms in the sample are family-owned businesses with a small
CCM proportion of public ownership, the investors may have discounted the firms heavier
13,4 by over-reacting to the unfavorable firm performance in the presence of information
asymmetry prevailing in the market.
The limited sample size and the unavailability of data for a new sample of
distressed firms prevent the validity and predictive accuracy assessment by cross
validation approach. The method of predictive assessment used in this paper may
292 lead to an upward bias in predictive accuracy of the functions and the chance
model criterion used. However, the values seem high enough to justify the use of the
model.
Consequently, the evidence documents that the logistic regression model serves to
predict corporate financial distress, in the presence of economic turbulence, with a
higher precision level than the discriminant method. The uncertainty in the economic
environment seems to reinforce the unfavorable impact of the managerial errors related
to financing decisions, growth strategies, and investments and tends to accelerate
financial distress.

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Appendix

Industry Number of firms

Textile and wearing apparel 24

Food, beverages and tobacco 8
Metal products 6
Chemicals and plastic products 6
Table AI. Basic metal 2
Industry classification of Industry based on stone and sand 4
the sample Paper and paper products 4

TOAS (Total assets/1000)/wholesale price index

CATA Current assets/total assets
SETA Shareholders’ equity/total assets
APNPTA Accounts payable þ notes payable/total assets
SCA Sales/current assets
SWC Sales/net working capital
STFA Sales/net tangible assets
QAS Quick assets/sales
GPM Sales-COGS/sales
QAI Quick assets/inventory
LTDTD Long-term debt/total debt
WCLTD Net working capital/long-term debt
MVETL Market value of equity/book value of total liabilities
CASH Cash þ marketable securities/current liabilities
FEFL Financial expenses/financial liabilities
FASE Fixed assets/shareholders’ equity
ROE Net income/shareholders’ equity
EBITPC EBIT/paid capital
EBITS EBIT/sales
Table AII. EBITDT EBITDA/total assets
List and measurement of OIBOIA Other income before taxes/other income after taxes
the selected variables VOL Annualized volatility of stocks’ daily returns in quarterly period
 Years prior to bankruptcy Prediction of
1 (%) 2 (%) 3 (%) 4 (%) corporate
Type I error
financial distress
Back et al. 13.51 27.03 16.22 n.a.
Base modela 10.4 11.4 18.2 30.0%
Type II error
Back et al. 13.51 29.73 35.14 n.a.
295
Base modela 3.1 2.8 4.4 4.8
Total error
Back et al. 13.51 28.4 25.7 n.a.
Base modela 5.5 5.7 9.0 12.9% Table AIII.
Comparative analysis of
Note: aModel developed in this paper errors – logit model

Corresponding author
Mine U
gurlu can be contacted at: ugurlum@boun.edu.tr

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