Scandinavian Working Papers in Economics

Working Paper Series,
Sveriges Riksbank (Central Bank of Sweden)

No 256: Taking the Twists into Account: Predicting Firm Bankruptcy Risk with Splines of Financial Ratios

Paolo Giordani (), Tor Jacobson (), Erik von Schedvin () and Mattias Villani ()
Additional contact information
Paolo Giordani: Research Department, Central Bank of Sweden, Postal: Sveriges Riksbank, SE-103 37 Stockholm, Sweden
Tor Jacobson: Research Department, Central Bank of Sweden, Postal: Sveriges Riksbank, SE-103 37 Stockholm, Sweden
Erik von Schedvin: CentER - Tilburg University, EBC, and Sveriges Riksbank
Mattias Villani: Division of Statistics, Department of Computer and Information Science, Linköping University

Abstract: We demonstrate improvements in predictive power when introducing spline functions to take account of highly non-linear relationships between firm failure and earnings, leverage, and liquidity in a logistic bankruptcy model. Our results show that modeling excessive non-linearities yields substantially improved bankruptcy predictions, on the order of 70 to 90 percent, compared with a standard logistic model. The spline model provides several important and surprising insights into non-monotonic bankruptcy relationships. We find that low-leveraged and highly profitable firms are riskier than given by a standard model. These features are remarkably stable over time, suggesting that they are of a structural nature.

Keywords: bankruptcy risk model; micro-data; logistic spline regression; …nancial ratios

JEL-codes: C41; G21; G33; G38

51 pages, November 1, 2011

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