The use of financial ratios to predict bankruptcy: A study of the board of directors on corporate performance

Financial ratios have predominantly been used in bankruptcy models to predict business failures. This study is a new approach to predict corporate failures that combined the accuracy of the traditional ratio-based bankruptcy (BK) model such as the Altman Z-Score Bankruptcy Model with a bankruptcy model that built upon the characteristics of the Board of Directors (BOD). The Altman 1993 revised four-variable BK model for non-manufacturing companies was retested on a selected group of publicly traded financial institutions to confirm the ratio-based model validity and accuracy in bankruptcy prediction. A BOD BK Model was developed and validated using the companies that the Altman model could not classify (Zone of Ignorance (ZOI), gray area) or misclassified (MIS). The BOD BK model used variables that were related to the board composition (size, tenure, CEO/Chair duality and external/internal directors' ratio) and board members' characteristics (experience, age and Groupthink). Board composition variables represent the board independence and impartiality and board members' characteristics represent the board competency. Seventy banks (35 failed and 35 non-failed) from 2006 to 2010 were chosen for the study. The financial data used for the study was from years one, two, and three prior to the banks filing for bankruptcy. Correlation tests between geographical location and total asset size to bankruptcy were conducted to determine if any relationship exists. Shifting the focus of bankruptcy prediction from using just financial ratios and moving towards the inclusion of variables from the BOD offers a better understanding of non-financial variables influencing organizational performance. This study shows that the non-ratio based BOD BK Model was able to improve Altman's Year 1 accuracy between twenty and fifty percent.