Aggregate economy risk and company failure: An examination of UK quoted firms in the early 1990s

Abstract

Considerable attention has been directed in the recent finance and economics literature to issues concerning the effects on company failure risk of changes in the macroeconomic environment. This paper examines the accounting ratio-based and macroeconomic determinants of insolvency exit of UK large industrials during the early 1990s with a view to improve understanding of company failure risk. Failure determinants are revealed from estimates based on a cross-section of 369 quoted firms, which is followed by an assessment of predictive performance based on a series of time-to-failure-specific logit functions, as is typical in the literature. Within the traditional for cross-sectional data studies framework, a more complete model of failure risk is developed by adding to a set of traditional financial statement-based inputs, the two variables capturing aggregate economy risk - one-year lagged, unanticipated changes in the nominal interest rate and in the real exchange rate. Alternative estimates of prediction error are obtained, first, by analytically adjusting the apparent error rate for the downward bias and, second, by generating holdout predictions. More complete, augmented with the two macroeconomic variables models demonstrate improved out-ofestimation- sample classificatory accuracy at risk horizons ranging from one to four years prior to failure, with the results being quite robust across a wide range of cutoff probability values, for both failing and nonfailed firms. Although in terms of the individual ratio significance and overall predictive accuracy, the findings of the present study may not be directly comparable with the evidence from prior research due to differing data sets and model specifications, the results are intuitively appealing. First, the results affirm the important explanatory role of liquidity, gearing, and profitability in the company failure process. Second, the findings for the failure probability appear to demonstrate that shocks from unanticipated changes in interest and exchange rates may matter as much as the underlying changes in firm-specific characteristics of liquidity, gearing, and profitability. Obtained empirical determinants suggest that during the 1990s recession, shifts in the real exchange rate and rises in the nominal interest rate, were associated with a higher propensity of industrial company to exit via insolvency, thus indicating links to a loss in competitiveness and to the effects of high gearing. The results provide policy implications for reducing the company sector vulnerability to financial distress and failure while highlighting that changes in macroeconomic conditions should be an important ingredient of possible extensions of company failure prediction models.