Before investors or lenders commit funds to a company, they’d love to have some assurance about the business’s viability. Could it, say, survive a brutal downturn?
Research by the University of Southern California’s Maria Ogneva, Stanford’s Joseph D. Piotroski, and Chicago Booth’s Anastasia A. Zakolyukina may provide some guidance. They have developed probability estimates—which can be used in risk-management assessment, in conjunction with conventional bankruptcy- or failure-risk measures—to identify companies that may be in particular danger of failing in recessions.
The researchers compared the characteristics of companies that failed during economic recessions or expansions, and evaluated accounting fundamentals that can predict the phase of the business cycle in which an enterprise may fail. They analyzed a sample of 3,511 business failures—including bankruptcies, performance-related delistings, and credit defaults—from January 1973 to December 2016, a period that covered six recessions.
With the help of a statistical-learning method, they identified 12 accounting fundamentals that could predict failure during a recession: enterprise size; age; the procyclicality of businesses’ profitability, profit margin, and sales; short-term borrowing; sales seasonality; profitability and profit-margin volatilities; the dividend payout ratio; and fixed-asset and research-and-development intensity. Although some of the identified fundamental variables are commonly seen in bankruptcy-prediction models, the risk that the researchers documented is quite different from conventional bankruptcy probability.
Unlike highly distressed companies, which can fail at any time, relatively healthy companies are more likely to be done in by hard times, the researchers argue. While the smaller and younger companies in the sample frequently fall into the former camp, the companies that failed during recessions tended to be older and larger. Although companies that failed had higher short-term borrowing than companies that didn’t, those that collapsed in recessions were on average less dependent on external financing than those that folded in expansions. Such businesses survived in expansions, and only a large adverse shock such as a recession pushed them into delinquency.
Homing in on companies at risk during a recession has broader implications for investors. According to the researchers, if an accounting variable could help predict these recessionary failures, it could also help identify characteristics associated with broader, systematic risk. And stock prices do reflect which companies are at risk in a recession, the researchers write. They sorted stocks, from healthy to distressed, by the probability of recessionary failure. As the probability went up, so too did expected returns.