64 financial ratios less likely to predict company failure than 6 qualitative measures.

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64 financial ratios less likely to predict company failure than 6 qualitative measures

Financial Prediction

If you asked people 6 questions about a company, or you researched 64 financial indicators about a company, which would you think was going to predict a company will fail within a year ?

Jacky C K Chow, Aston Business School, Birmingham University knows the answer. Chow’s MBA dissertation[1], which studied and compared the options available. During her research, Chow looked at different methodologies of Machine learning to understand and predict the financial distress of a company. Using methods such as Linear Regression, Decision trees, Artificial Neural Networks amongst others, Chow took the available data on companies in Poland to generate predictions on the financial future of companies.

Also undertaken was the analysis, using the same methodologies, of second dataset from a previous study which had six qualitative measures (Industrial risk, Management risk, Financial Flexibility, Credibility, Competitiveness, Operating Risk ) from loan experts.

The results gave a very distinct answer. The loan experts qualitative answers, when analysed gave a better indication of insolvency than the 64 financials [see table below]. Furthermore, her findings indicated that by asking 4 questions of the loan experts on a company, their combined answers, could then be analysed via decision tree classifier to give a 90% accurate prediction. The cost of collecting from financial experts is more expensive. Also noted was that quality control must be applied as in some techniques the conclusion can easily be biased.

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[1] Jacky C K Chow, Analysis of Financial Credit Risk Using Machine Learning, 2017

64 Financial Measures

  • 1 net profit / total assets
  • 2 total liabilities / total assets
  • 3 working capital / total assets
  • 4 current assets / short-term liabilities
  • 5 [(cash + short-term securities + receivables - short-term liabilities) / (operating expenses - depreciation)] * 365
  • 6 retained earnings / total assets
  • 7 EBIT / total assets
  • 8 book value of equity / total liabilities
  • 9 sales / total assets
  • 10 equity / total assets
  • 11 (gross profit + extraordinary items + financial expenses) / total assets
  • 12 gross profit / short-term liabilities
  • 13 (gross profit + depreciation) / sales
  • 14 (gross profit + interest) / total assets
  • 15 (total liabilities * 365) / (gross profit + depreciation)
  • 16 (gross profit + depreciation) / total liabilities
  • 17 total assets / total liabilities
  • 18 gross profit / total assets
  • 19 gross profit / sales
  • 20 (inventory * 365) / sales
  • 21 sales (n) / sales (n-1)
  • 22 profit on operating activities / total assets
  • 23 net profit / sales
  • 24 gross profit (in 3 years) / total assets
  • 25 (equity - share capital) / total assets
  • 26 (net profit + depreciation) / total liabilities
  • 27 profit on operating activities / financial expenses
  • 28 working capital / fixed assets
  • 29 logarithm of total assets
  • 30 (total liabilities - cash) / sales
  • 31 (gross profit + interest) / sales
  • 32 (current liabilities * 365) / cost of products sold
  • 33 operating expenses / short-term liabilities
  • 34 operating expenses / total liabilities
  • 35 profit on sales / total assets
  • 36 total sales / total assets
  • 37 (current assets - inventories) / long-term liabilities
  • 38 constant capital / total assets
  • 39 profit on sales / sales
  • 40 (current assets - inventory - receivables) / short-term liabilities
  • 41 total liabilities / ((profit on operating activities + depreciation) * (12/365))
  • 42 profit on operating activities / sales
  • 43 rotation receivables + inventory turnover in days
  • 44 (receivables * 365) / sales
  • 45 net profit / inventory
  • 46 (current assets - inventory) / short-term liabilities
  • 47 (inventory * 365) / cost of products sold
  • 48 EBITDA (profit on operating activities - depreciation) / total assets
  • 49 EBITDA (profit on operating activities - depreciation) / sales
  • 50 current assets / total liabilities
  • 51 short-term liabilities / total assets
  • 52 (short-term liabilities * 365) / cost of products sold)
  • 53 equity / fixed assets
  • 54 constant capital / fixed assets
  • 55 working capital
  • 56 (sales - cost of products sold) / sales
  • 57 (current assets - inventory - short-term liabilities) / (sales - gross profit –depreciation)
  • 58 total costs /total sales
  • 59 long-term liabilities / equity
  • 60 sales / inventory
  • 61 sales / receivables
  • 62 (short-term liabilities * 365) / sales
  • 63 sales / short-term liabilities
  • 64 sales / fixed assets

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