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CFO Fundamentals: Your Quick Guide to Internal Controls, Financial Reporting, IFRS, Web 2.0, Cloud Computing, and More by ALLISON I. SHIM, JOEL G. SIEGEL, JAE K. SHIM

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CHAPTER THIRTY-EIGHT

Forecasting Corporate Financial Distress

THERE HAVE BEEN an increasing number of bankruptcies in recent years. Will your company be one? Will your major customers or suppliers go bankrupt? What warning signs exist, and what can be done to avoid corporate failure?

Bankruptcy is the final declaration of a company’s inability to sustain current operations given current debt obligations. The majority of firms require loans and therefore increase their liabilities during their operations in order to expand, improve, or even just survive. Current debt in excess of assets is the most common factor in bankruptcy.

If you can recognize ahead of time that your company is developing financial distress, you can better protect yourself and your company. The CFO can reap significant rewards and benefits from a predictive model. For example, a predictive model is useful for:

  • Merger analysis. The predictive model can help identify potential problems with a merger candidate.
  • Legal analysis. Those investing or giving credit to your company may sue for losses incurred. The model can help in your company’s defense.

CFOs have to try to build early warning systems to detect the likelihood of bankruptcy. Although financial ratio analysis is useful in predicting failure, it is limited because the methodology is basically univariate. Each ratio is examined in isolation, and the CFO must use professional judgment to determine whether a set of financial ratios are developing into a ...

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