An Empirical Test of Financial Ratio Analysis for Small Business Failure Prediction

Author(s): Robert O. Edmister

Reviewed work(s):
Source: The Journal of Financial and Quantitative Analysis, Vol. 7, No. 2, Supplement: Outlook
for the Securities Industry (Mar., 1972), pp. 1477-1493
Published by: University of Washington School of Business Administration
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JOURNAL OF FINANCIALAND QUANTITATIVE
ANALYSIS
March 1972

AN EMPIRICAL TEST OF FINANCIAL RATIO ANALYSIS

FOR SMALLBUSINESS FAILURE PREDICTION

Robert 0. Edmister*

The purpose of this research is to test the usefulness of financial

ratio analysis for predicting small business failure. Altman [1], Beaver [4]
and [5], and Blum [6] have advanced empirical research of financial analysis
in recent years by applying sophisticated statistical techniques to financial
data of firms that became bankrupt or otherwise failed,and firms that appeared
successful. Their research has indicated that analysis of selected ratios is
useful for predicting failure of medium and large asset-size firms. However,
these and previous studies have largely ignored small businesses because of
the difficulty of obtaining data.

I. Recent Studies
William H. Beaver's 1966 study [4] warrants its distinction as a "land-
mark for future research in ratio analysis" because Beaver introduced a
sophisticated statistical technique for direct analysis of an unlimited number
of cases and because he computed ratios from funds' statement data. Beaver
defined failure as a business defaulting on interest payments on its debt,
overdrawing its bank account, or declaring bankruptcy. Using univariate dis-
criminant analysis, he studied large asset-size firms which failed during 1954-
1964 and a stratified sample of successful firms. Beaver found that the ratio
of annual cash flow to total debt misclassified only 13 percent of the sample
firms one year before bankruptcy and 22 percent of the sample firms five years
before bankruptcy. In a later reference to this study, Beaver [5] said:
This evidence . . . suggested that financial ratios can
be useful in the prediction of failure for at least five

*Purdue University. This paper is based on the author's doctoral dis-

sertation compZeted at Ohio State University in 1970. The author gratefully
acknowZedges the assistance of John PfahZ, his dissertation advisor, and Robert
Johnson, David Cole, and Roger Harvey. The research was supported by a grant
from Robert Morris Associates and was conducted in cooperation with the Small
Business Administration, but the author assumes sole responsibility for the
results and conclusions presented here.

1477
 years prior to the event; . . . the user cannot choose
among ratios indiscriminantly. Persistent differences
in predictive ability were found, many of which were
not correctly anticipated by a priori arguments in the
literature.
Edward I. Altman [1] attempted to assess the quality of ratio analysis
as an analytical device in predicting bankruptcy of firms ranging in size from
$0.7 million to $25.9 million in assets. A group of 33 manufacturing firms
declaring bankruptcy under Chapter X during the period 1946-1965 was paired
with a stratified sample of 33 manufacturing firms not declaring bankruptcy.
From an initial list of 22 variables, Altman selected the following ratios for
a discriminant function: working capital/total assets, retained earnings
before interest and taxes/total assets, market value of equity/book value of
total debt, and sales/total assets. F-ratios for each variable and the entire
equation were calculated and found significant for all but the sales/total
assets ratio. The predictive ability of the function on a 66-firm holdout
sample was 79 percent one year before failure.
Blum [6] constructed a model, based upon accounting and financial market
data, to be used as a defense in antitrust cases under the "Failing Company
Doctrine." Defining failure as "entrance into a bankruptcy proceeding or an
explicit agreement with creditors which reduced the debts of the company,"
Blum assembled a sample of 115 industrial firms which failed during the years
1954-1968 (with liabilities greater than $1 million) and a paired sample of 115
nonfailing firms similar with respect to industry, annual sales, number of em-
ployees, and fiscal year. Data up to eight years prior to failure were col-
lected when available; however, five years of data prior to failure were found
optimal. Based upon validation sample tests, Blum concluded that his model had
an accuracy of 93 to 95 percent when failure occurred within one year of the
statement date. The accuracy declined to 80 percent for predictions two years
prior to failure and 70 percent for predictions three years prior to failure.
Comparison of Recent Ratio Research
A summary of ratios included in the three recent empirical studies is
presented in Table 1. These studies showed that a few ratios can be combined
to make a discriminant function with a high degree of reliability when applied
to data similar to that which determined the function. Although some ratios
were found to be good predictors in more than one study, no one group of ratios
is common to the four studies. This implies that the discriminant functions
can be applied reliably only to situations very similar to those from which the
function was generated. In like manner, the research results to be presented
next were based upon Small Business Administration (SBA) loan records and are
relevant only to the analysis of SBA guarantee recipients.

1478
 TABLE 1
SUMMARYOF RATIOS FOUNDTO BE SIGNIFICANT
PREDICTORSOF BUSINESS FAILURE IN RECENT
EMPIRICAL RESEARCHa

Researcher
Ratio Altman Beaver Blumb

Net working capital/total assets X X

Debt/total assetsc X X
Total assets turnover X
Net operating margin X
Earnings after taxes/total assets X
Market value of equity/book value of
total debt X
Cash flow/total debt X X
Trend Breaks of Net Quick Assets to
Inventory X
Net Quick Assets to Inventory X
Rate of Return to Common Shareholders X

aThese studies varied in purpose and scope; reference is made to the

text for a discussion of the definition of failure and population studied in
each case.

bThe 12-variable function was estimated for many time periods and
the results varied widely. These five variables generally performed best over
all of the time periods.

cDefined as debt to net worth in some of the studies.

II. Research Design

This study examines 19 common ratios and five prevailing methods of
analysis. Multiple discriminant analysis is employed to select a set of ratios
and analytical methods which best discriminate between loss and nonloss borrow-
ers and guarantee recipients from the Small Business Administration. Presented
next are the 19 ratios selected, the five hypothesized methods of ratio
analysis, a description of the SBA data, and a brief review of multiple dis-
criminant analysis.
Ratio Selection
Ratios selected for this study have been advocated by theorists or have
been found to be significant predictors of business failure in previous empiri-
cal research. While the list of ratios is not exhaustive, it does contain all
ratios emphasized by the theorists except those requiring accounts receivable

1479
and accounts payable information. It contains all ratios found significant in
previous empirical studies except the net operating margin ratio. Data for the
ratios excluded are not available for this research. Ratios included are the
quick, current, inventory/net working capital, net working capital/total assets,
current assets/total debt, total debt/equity, fixed assets/equity, cash flow/
current liabilities, current liabilities/equity, equity and long-term debt/
fixed assets, inventory/sales, fixed assets/sales, total assets/sales, net work-
ing capital/sales, equity/sales, earnings before taxes (EBT)/sales, EBT/total
assets, EBT/equity, and EBT plus depreciation/total debt.
The first hypothesis is that a ratio's level is a predictor of small
business failure. For example, a firm is believed less likely to fail if its
current ratio is 3/1 rather than 1/1. This hypothesis represents the use of
ratios in their crudest form; no adjustment is made for variations between
industries nor are the ratios compared with one another. It is based upon the
theory that there are standards which transcend industry boundaries and are
applicable to all firms.
The relative level of the borrower's ratio to the average ratio of other
small businesses in the same industry is hypothesized to be a predictor of
small business failure. Support for including an industry adjustment is wide-
spread and the popularity of industry comparisons is indicated by the prolific
construction and publication of industry summaries by Robert Morris Associates
(RMA), Dun & Bradstreet, and others. To test this hypothesis empirically,
variables denoted as RMArelatives are calculated by dividing the original
ratios by Robert Morris Associates' Annual Statement Studies [15] average
ratios for firms in a similar industry and of similar size.1 SBA relative
variables are likewise computed using SIC industry averages compiled from
45,000 statements submitted by Small Business Administration borrowers.
The second hypothesis is that the three-year trend of each ratio is a
predictor of small business failure. Previous empirical studies considering
trends have found that trends of some ratios lead to business failure [6, 14,
and 16]. Practitioners report that businesses which are "going in the wrong
direction" are viewed with greater caution than those whose trends are improv-
ing. Trend is defined as three consecutive years in which the ratio moves in

1A potential problem with this technique is that industry-borrower rela-

tive ratios such as -1:2 and 1:-2 are computationally equivalent (-.5:1).
Clearly, these ratios convey entirely different meanings and this occurrence
is likely to mislead the analyst. However, industry composite ratios are
rarely negative and, therefore, the problem is minimal in practice.

1480
the same direction.2 For example, if the ratios for the last three years were
2/1, 3/1, and 4/1, a trend is defined; but if the ratios were 2/1, 4/1, and 3/1,
a trend is not considered to exist. Up-trend dummy variables are assigned a
value of 1 for an increasing trend and 0 otherwise; down-trend dummy variables
are assigned the value 1 for a decreasing trend and 0 otherwise.
A third hypothesis is that the three-year average of a ratio is a pre-
dictor of small business failure. Averaging is expected to smooth the ratios
and to result in a more representative figure than that calculated from only
the most recent statement. Averages are calculated for the RMArelative and
SBA relative ratios to provide an index of the relative firm-to-industry posi-
tion over three years.
A fourth hypothesis is that the combination of the industry relative
trend and the industry relative level for each ratio is a predictor of small
business failure. This hypothesis has not been presented in previous empirical
research but is an explicit representation of the conditional nature of ratios
long recognized by ratio analysts. The trend-level joint condition is sug-
gested by Weston and Brigham [18]:
Although Composite Company's current ratio is below
the industry average, a credit analyst would not mark
the firm down badly on this count, in view of the
favorable trend.
This subjective analysis is statistically interpreted as an interaction
between two variables correlated with the occurrence of a third event. Any
number of variables may interact in this manner, although the variables,
singularly, may not have a significant relationship with the dependent vari-
able. Even though linear models such as linear regression or MDAdo not repre-
sent interaction when the interaction is not specified, the problem of inter-
action effects has been neglected in previous research.3 As illustrated by
Weston and Brigham's statement, a conditional relationship between two or more
ratios may be a predictor. Allowing for interactions between ratios is likely
to result in a model that more accurately reflects the basic theoretical con-
structs. In our case, a given trend may not portend failure because an equal
number of failed and successful borrowers shows the same trend, and a given
level may not be a failure indicator for the same reason. However, a trend-
level combination may appear only for failed borrowers or successful borrowers.

2Generally, trend is defined statistically as a significant relationship

between a dependent variable and time. Trend may be discerned in many ways,
but a runs count is selected because it is a simple yet reliable test when
only three observations are available.

3See Sonquist [17], Table 3, p. 37, for a description of interaction

conditions given two dichotomous independent variables.

1481
Such a combination may be a debt/equity ratio increasing over three years to a
high level or a current ratio declining over three years to a low level. After
extensive research on interaction, Sonquist [17] concludes that linear models
provide an adequate representation of interaction effects when the relation-
ships are specified. This study specifies four combinations (trend up-high
level, trend up-low level, trend down-high level, and trend down-low level) for
each of the RMAand SBA relatives. The 152 combination variables thus formed
are a subgroupof the 2 19+24 two-variable interaction terms possible for the 19
ratios and 24 basic variables defined under the first four hypotheses. Con-
sideration of all possible interaction terms is undesirable, not only because
their calculation is extremely laborious but also because spurious correlation
and interdependence are likely to lead to a theoretically unreasonable and
empirically unstable model.
Statistical Methodology
The statistical problem in this research is one of classifying an indi-
vidual business as a member of one of two classes, success or failure, based
upon a number of ratio variables. As in previous studies, multiple discriminant
analysis (MDA) is used to form a linear model which classifies individual cases
based upon historical financial ratios. The application of MDA to the problem
of failure prediction is described by Altman [1]. The geometric interpretation
of MDA can best be depicted for the case of two variates and, as in this study,
two groups. The bivariate plot for groups I and II is shown in Figure I. The
two variables X and Y are slightly positively correlated, as illustrated. For
each group, the locus of points of equal density is indicated by an ellipse
called a centour (centile contour).
A straight line is defined by the two points where the centours inter-
sect. If a second line Z is constructed perpendicular to line A and if the
points in the X-Y space are projected onto Z, the overlap between the two dis-
tributions will be the smallest line. The individual characteristics are
transformed by the discriminant function into a single discriminant score Z
located on Z. A point such as b divides the one-dimensional space into two
regions, each having a probability of membership in I or II [12].
Although the problem of intercorrelation has been expressed in previous
ratio research, a procedure for limiting intercorrelation has not been
described [1]. Intuitively, one expects ratios to be highly multicollinear
because many ratios are formed from a common set of financial accounts. Low
levels of intercorrelation present few problems, but as the data set becomes
increasingly multicollinear, the problem becomes increasingly severe. The cor-
relation matrix approaches singularity and elements of the inverse matrix
(X'X) 1 explode as the degree of interdependence among explanatory variables X

1482
 FIGURE I

y A

II
1

1483

1483
grows. In the limit, the correlation matrix is singular and the set of para-
meter estimates is indeterminant. The result for MDA is the same as that for
regression described by Farrar and Clauber [9]: "Attempts to apply regression
techniques to highly multicollinear independent variables generally result in
parameter estimates that are markedly sensitive to changes in model specifica-
tion and to sample coverage. . . . Successful forecasts with multicollinear
variables require not only the perpetuation of a stable dependency relation-
ship between Y and X, but also the perpetuation of stable interdependency re-
lationships within X."
In this research a limitation is placed on variables entering a dis-
criminant function through the normal step-wise procedure in order to limit
multicollinearity while systematically selecting variables. The second and
subsequent variables having a significant (.95) simple correlation-coefficient
with an included variable are excluded from the set of variables free to enter
the function at each step. A variable is not permitted to enter if its simple
correlation coefficient with a variable already in the function is greater
than .31 (actually, the largest correlation between any two independent vari-
ables in the function presented in the next section is .23). After three or
four variables are accepted, the number of variables free to enter the function
is substantially reduced by this requirement because ratios tend to be highly
intercorrelated. Although this method is somewhat arbitrary, the most obvious
type of pair-wise interdependence is avoided. Due to the unusually tight con-
straint placed on the simple correlation coefficients, a high degree of confi-
dence is maintained with respect to the independence of the predictor vari-
ables.
The two-group case of MDA has the unique and useful characteristic of
being proportional to regression when the regression dependent variable is given
the dichotomous values of 0 and 1. Anderson [3] shows that the relationship
between the discriminant coefficients and the regression coefficients is pro-
portional. Hence, the somewhat better developed multiple regression computer
programs are used in this special case.
Data Sources
The data for testing the hypotheses are provided by the Small Business
Administration and Robert Morris Associates. The SBA data are drawn from the
Financial Growth Data Bank containing 192,000 statements submitted by SBA bor-
rowers during the period 1954-1969 and reported in a condensed, standard for-
mat. Based upon the following restrictions, 42 borrowers are selected for
inclusion in this study:
1. Three consecutive annual statements are available prior to
the date when the loan was granted.

1484
 2. The financial statements report operations for the years
1958-1965. (All loans included in the study are at least
three years old.)
3. Statements report a nonzero amount for current assets and
net sales (completeness requirement).
4. Corresponding RMAcomposite statements exist.
5. Corresponding SBA composite statements exist.
6. The test sample contains an equal number of loss and non-
loss cases.
If the sample is drawn on the basis of all of the above restrictions,
all the hypotheses can be tested but the sample size will be relatively small
(although large enough to conduct statistical tests). If the sample is drawn
with the less restrictive requirement of one annual statement prior to the
final action date, only the first two hypotheses can be tested but the sample
size will be relatively large (562). Studying both samples incorporates the
advantages of each and provides a check on the bias entered in the more re-
strictive sample as a result of the additional screening. Furthermore, tests
may be conducted on the larger sample to determine the effectiveness of the
multicollinearity restriction. The more restrictive and smaller sample will be
called the "tri-annual sample" and the less restrictive and larger sample will
be denoted the "mono-annual sample." The mono-annual and tri-annual samples
contain 100 percent of the loss cases applicable to each and 15 percent and
19 percent, respectively, of the nonloss mono-annual and tri-annual loans. The
nonloss loans are selected randomly from cases meeting the restrictions. Given
the above restrictions, this procedure provides a maximumsample size.
The average tri-annual borrower for the year ending just prior to loan
has current assets of $82,910 including inventory of $42,000, other (fixed)
assets of $82,025, total assets of $164,940, current liabilities of $69,795,
other (long-term liabilities of $29,430) net worth of $65,665, net sales of
$407,460, and profit before taxes of $14,635. Failures showed smaller amounts
in every account but nonfailures, and the difference was significant (.95 level
of confidence) for inventory ($23,400 versus $60,770) and profit ($12,500 ver-
sus $16,770 for failures and nonfailures, respectively).
Validation of the Discriminant Model
Sample estimates of a model's predictive power may be subject to a bias.
The proportion of observations correctly classified in the discriminant analy-
sis may be due to three factors: (1) true differences between the groups,
(2) sampling errors, and (3) intensive search for the variables that work best
for the sample. The objective of a validation procedure is to determine what
part of the observed proportion of correctly classified observations is due to
the true differences between the two-group means.

1485
 Frank, Massy, and Morrison [12] describe two validation procedures for
determining an unbiased estimate of the predictive power of a multiple dis-
criminant function. The split (sometimes called "hold-out") sample approach is
recommended by them as the preferred method when a large sample is available
and will be used for the mono-annual sample. (The tri-annual sample, contain-
ing only 42 observations, is too small for the split sample approach.) If the
split sample is used, the analysis sample is likely to have as few as 13 de-
grees of freedom and the validation sample approach, also suggested by Frank,
Massy, and Morrison, is applied using the original variance-covariance matrix.
The procedure is outlined as follows:
1. The coefficients of the two discriminant functions and a
classification table are generated with the original sample.
2. The original data is "scrambled" by reassigning individuals
to populations at random.
3. Discriminant coefficients are estimated from the scrambled
data and the associated classification tables are generated
and evaluated.
Since the method of reassigning observations to the two populations
insures that the expected discriminatory power of the analysis is zero, the
discriminatory power given by the scrambled sample classification table may be
interpreted as a measure of the bias associated with the given numbers of de-
grees of freedom. Binomial distribution theory may be used for the following
t test:
t
p
where:
Q is the proportion of sample observations correctly classified
by the discriminant analysis,
P is the proportion one expects by chance, and

ar is isP(l-P)
p h-1

III. Results
The major objective of this research is to determine whether or not
financial ratios may be analyzed so as to predict the future failure or non-
failure of a small business. Toward this goal, the research yields results
that generally affirm the advocates' belief in the value of ratio analysis and
that lend some support for numerical credit scoring. A discriminant function,
which is not only statistically significant (.01 level) but also sufficiently
accurate to be of practical significance, is estimated. However, attempts to
find an accurate function based solely upon one annual financial statement for
each business prove fruitless when tested on the validation sample and synthetic

1436
sample for the mono-annual (282 observations) and tri-annual (42 observations)
samples, respectively. Some single-year ratios are good predictors, however,
and two of these are presented next. The function presented here is based
upon the tri-annual sample and is selected and estimated using the step-wise
multiple discriminant analysis procedure described previously. It should be
noted that other functions of almost the same quality are possible using vari-
ables excluded because they are highly correlated with those included.
Furthermore, some ratios that are significant in screening failed from success-
ful businesses may not appear here because SBA credit analysts may have already
used these ratios to eliminate applicants who would fail.
The seven-variable function estimated on the tri-annual sample follows:

z = .951 - .423X1 - .293X2 - .482X3

(-4.24**) (-2.82**) (-4.51**)
+ .277X4 - . 452X5 - .352X6 -.924X7
(2.61*) (-2.60*) (-1.68) (-7.11*)
2
R = .74 F-ratio = 14.02**
Significance levels * - .05; ** = .01

z = 1 for a successful (nonloss) business and z = 0 for a failed (loss)

business.

X1 = 1 if the annual funds flow/current liabilities ratio is less than .05;

otherwise X1 = 0. As might be expected, an extremely low funds flow
relative to short-term commitments is a predictor of failure.4 Profit
after taxes is not available from the SBA, and funds flow is defined as
net profit before taxes plus depreciation.

X2 = 1 if the equity/sales ratio is less than .07; otherwise X2 = 0. Failure

is also more likely for firms with a small equity base for their sales
irrespective of their industrial classification.

X3 = 1 if the net working capital/sales ratio divided by its respective RMA

ratio is less than -.02; otherwise X3 = 0. A relatively high (to RMA)
working capital turnover portends failure.

4For the purpose of this discussion, ratio expectations are implied from
the selection of ratios and quartile sizes made by Dun & Bradstreet and Robert
Morris Associates. Dun & Bradstreet [13] computes 14 ratios and arranges the
quartiles "so that the best figure is at the top, the weakest at the bottom."
Likewise, Robert Morris Associates [15] calculates 11 ratios of which six are
equivalent to D & B in computation and "best" quartile classification. Since
these ratios are published by credit-related organizations, it is assumed they
relate to risk of failure rather than some other objective such as profit-
ability.

1487
X4 = 1 if current liabilities/equity divided by the respective SBA ratio aver-
ages less than .48; otherwise X4 = 0. Confirming long-held beliefs, a
low debt-to-equity ratio relative to the industry reduces the chance of
failure.

X5 = 1 if the inventory/sales ratio divided by the respective RMAratio has

shown an up-trend and is still less than .04; otherwise X5 = 0. The in-
verse of this ratio is the inventory turnover. A borrower with a very
high but declining inventory turnover relative to the RMA industry average
is a potential failure.

X = 1 if the quick ratio/RMA trend is down and its level just prior to the
6
loan is less than .34; otherwise X6 = 0. Only two firms show this char-
acteristic of a low and declining RMArelative quick ratio, but they both
failed.

X7= 1 if the borrower's quick ratio divided by the RMAquick ratio shows an
up-trend; otherwise X7 = 0. The negative sign in front of this variable's
coefficient indicates that an increasing RMArelative quick ratio portends
failure. One possible explanation for this surprising result is that
creditors are refusing to grant credit or that credit is not needed due to
poor business prospects.
Accuracy of the Function
The seven-variable function correctly discriminates in 39 out of 42 cases
(93 percent) when the decision rule is to predict failure if z < .520 and non-
failure if z > .520. The analysis sample was tested with the synthetic sample
validation approach and found to be better (significantly at the .99 level of
confidence) than the validation sample. The decision rule may be altered so
that the predictive accuracy of one condition may be improved, the improvement
usually being obtained at the expense of a decrease in predictive accuracy of
the other condition. A list of z-scores for corner points from 100 percent pre-
diction of success follows. The small number of corner points is due primarily
to the sample size and, if the sample size is increased, the number of corner
points will increase to the number of values possible for the discriminant
function.
Predictive Accuracy
z-score Failure Nonfailure
up to .469 80% 100%
.470 to .519 85% 95%
.520 to .529 90% 95%
.530 and above 100% 86%

1488
 The z-score cutoff should be selected so as to equate the probability
of Type I and Type II errors with the ratio of the explicit cost of accepting
a failure to the opportunity cost of rejecting a success. This may be repre-
sented by the following equality:

P MC
P MC

where:
PI is the probability of rejecting a loan to a successful firm
(Type I error),
P is the probability of accepting a loan to a failing firm
(Type II error),
MC is the marginal opportunity cost of rejecting a loan to a
successful firm, and
MC is the marginal actual cost of accepting a loan to a failing
firm.
This analysis provides the logical solution for the z-score cutoff for
lenders who know their marginal costs. Since many lenders do not have suf-
ficient cost accounting systems to estimate MCI and MCII accurately, they will
find this type of analysis impractical. A practical alternative for setting
up z-score decision rules may be called the "black-gray-white" method. Given a
large number of loan applicants, calculated z-score frequencies may appear as
in Figure II. The loss and good loan distributions are separated.

Figure II

Frequency Black Gray White

of Z-Score

LOSS GOOD
LOANS LOANS

0.47 0.53 Z-Score Value

Since z-scores less than .47 were made only to loss borrowers, rejecting
all applicants who score less than .47 can serve only to improve the loan port-
folio. The white area to the right of .53 contains only nonloss applicants who
would be accepted with little additional analysis. Between the black and white
area lies the gray area, which requires the analyst's greatest efforts and
skills. Nonfinancial statement information regarding management, markets, plant
and equipment, and other factors would be scrutinized in order to classify the
applicant as a loss or nonloss borrower.
1489
Choice of Methods of Ratio Analysis
The predictive power of ratio analysis appears to be dependent upon the
choice of analytical methods as well as the selection of ratios. The method
of analysis should be suited to the ratio being examined to obtain maximum
discriminatory power. However, some of the methods generally found useful are
described in this section.
Dividing a ratio by its respective industry average is shown to be a
desirable technique. Five of the seven variables employing industry averages
and other tests, not reported here, consistently support the use of industry
comparisons. Because the SBA averages and the test sample are drawn from the
same population, the author would expect the SBA averages to be more relevant
and less subject to industry misclassification than the RMAStatement Studies.
(RMA classes do not coincide exactly with the SIC used by the SBA.) However,
the RMAStatement Studies' averages are clearly superior to the specially con-
structed SBA composite averages. The RMAaverages are concluded to be useful
in the prediction of small business failure, and the construction of an SBA
average appears to offer little advantage.
Classifying ratios by quartile is a particularly valuable tool, as
demonstrated by the use of quartiles in every variable of the comprehensive
function. In additional tests conducted on subsamples of the variables, quar-
tile variables generally dominated the respective continuous variables as com-
petitors for inclusion in the function. Quartile classification is a valuable
technique for two reasons. First, extreme values are negated and are therefore
prevented from unduly affecting the function parameters. Second, combinations
of level and trend require dichotomous data and these combinations sometimes
reveal characteristics otherwise unobservable.
Cumulative Power of Ratios
It is also interesting to note that the predictive power of ratios is
cumulative. No single ratio predicts nearly as well as a small group, and
some ratios that are not significant predictors by themselves serve to improve
discriminant ability when added to a function. However, when ratios are added
without consideration of independence to an analysis with ratios already in-
cluded, the real predictive power of the analysis does not increase. The
illusory effect of multicollinearity is clearly evident in tests conducted
with the mono-annual sample. A function is estimated on the analysis sample in
the usual step-wise manner but no restriction is placed on the independence of
the entering variables.
Variables entering the function tend to be highly correlated (.6 and.7
are common with n = 280), and sign changes and variable deletions are common as
the procedure progresses from step to step. The resulting function contains

149 0
25 variables and discriminates with an accuracy of 75 percent on the analysis
sample. When this function is applied to the validation sample, the discrimi-
nant accuracy declines to 57 percent (not significantly different from chance
at the .99 level of confidence). Although this test is not conclusive, it does
support the simple correlation restriction procedure as a means of selecting
independent variables from a set of variables containing high levels of multi-
collinearity.
It appears that, in practice as well as theory, reliable functions are
most likely formed with a set of independent predictors. Since ratios tend to
be very similar in their information content, great care has to be taken to
select a group that is as diverse as possible. This leads to an important
implication for the ratio analyst: maximum advantage is most likely obtained
by selecting one ratio for each different characteristic of the borrower's
business. Selecting more than one ratio for each characteristic is likely to
result in additional computational and analytical effort without materially
improving the credit analyst's ability to evaluate correctly an applicant's
credit worthiness. Previous empirical research generally confirms the view
that a small number of carefully selected ratios are as useful as many ratios
in predicting business failure.

IV. Summary
This study develops and empirically tests a number of methods of analyz-
ing financial ratios to predict small business failure. Although not all of
the methods and ratios are predictors of failure, many ratio variables are
found which do predict failure of Small Business Administration borrowers and
guarantee recipients. Using step-wise multiple discriminant analysis with a
restriction on the simple correlation of the entering variable with the included
variables, a function of independent ratio variables,which is highly accurate
in classifying borrowers in the test sample, is developed. Methods of analysis
found useful are (1) classification of a borrower's ratio into quartiles rela-
tive to other borrowers in the sample, (2) observation of an up- or down-trend
for a three-year period, (3) combinatorial analysis of a ratio's trend and
recent level, (4) calculation of the three-year average, and (5) division of a
ratio by its respective RMA industry average ratio. The discriminant function
demonstrates an ability as great as those functions recently estimated for
much larger firms. However, the small business function fails to discriminate
when only one statement is available, whereas Altman [1] and Beaver [4, 5] show
that one financial statement is sufficient for a highly discriminant function
for large businesses. This leads the author to qualify his conclusion above
with the provision that at least three consecutive financial statements be
available for analysis of a small business.
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 While ratio analysis may be specifically described in terms of present
conditions and future events, the algorithms appear highly complex. Correspond-
ing to each ratio is an optimum analytical method, such as averaging or divi-
sion by an industry standard. Multiple discriminant analysis offers one means
of selecting an optimal set of ratios and methods and of assigning weights to
obtain a relatively simple function. Analysts interested in predicting small
business failure may find this function not only a more accurate method but
also a more efficient technique than the subjective processes currently
practiced.

REFERENCES

[1] Altman, Edward I. "Financial Ratios, Discriminant Analysis and the Pre-
diction of Corporate Bankruptcy." The Journal of Finance, XXIII,
September 1968.

[2] _ . "A Reply" (to "Ratios Analysis and the Prediction of Firm Fail-
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1172.

[3] Anderson, T. W. An Introduction to Multivariate Statistical Analysis.

New York: John Wiley & Sons, Inc., 1958.

[4] Beaver, William H. "Financial Ratios as Predictors of Failure."

Empirical Research in Accounting: Selected Studies, 1966, University of
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[5] . "Alternative Accounting Measures as Predictors of Ftilure."

The Accounting Review, XLIII, January 1968.

[6] Blum, Marc Paul. "The Failing Company Doctrine." Ph.D. diss., Columbia
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[7] Cooley, William W.,and Paul R. Lohnes. Multivariate Procedures for the
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[8] Edmister, Robert 0. "Financial Ratios as Discriminant,Predictors of

Small Business Failure." Ph.D. diss., Ohio State University, 1970.

[9] Farrar, Donald E., and Robert R. Glauber. "Multicollinearity in Regres-

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[10] Fisher, R. A. "The Use of Multiple Measurements in Taxonomic Problems."

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[11] Frank, Ronald E., William R. Massy, and Donald G. Morrison. "Bias in
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[12] Johnson, Craig G. "Ratio Analysis and the Prediction of Firm Failure."
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[13] Key Business Ratios in 125 Lines - 1964. New York: Dun & Bradstreet,
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[14] Merwin, Charles L. Financing Sma11 Corporations. New York: National
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[15] Robert Morris Associates Annual Statement Studies. Philadelphia: Robert

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[16] Smith, Raymond F., and Arthur H. Winakor. "Changes in the Financial
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[17] Sonquist, John A. Multivariate Model Building. Ann Arbor, Michigan:

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[18] Weston, J. Fred, and Eugene F. Brigham. Managerial Finance, 2nd ed.
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