Aggregate Economy Risk and Company Failure: An Examination of UK Quoted Firms

35 Pages Posted: 14 Nov 2008 Last revised: 15 Jul 2012

See all articles by John Hunter

John Hunter

Brunel University - School of Social Science

Natalia Isachenkova

Kingston Business School

Date Written: March 17, 2006

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 of estimation 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 cut-off probability values, for both failing and non-failed 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.

Keywords: Company Failure, Aggregate Economy Risk, Unexpected Changes in Interest and Exchange

JEL Classification: G33

Suggested Citation

Hunter, John and Isachenkova, Natalia, Aggregate Economy Risk and Company Failure: An Examination of UK Quoted Firms (March 17, 2006). Available at SSRN: https://ssrn.com/abstract=1299056 or http://dx.doi.org/10.2139/ssrn.1299056

John Hunter (Contact Author)

Brunel University - School of Social Science ( email )

Kingston Lane
Uxbridge, Middlesex UB8 3PH
United Kingdom
00-44-1895-266648 (Phone)

HOME PAGE: http://www.brunel.ac.uk/about/acad//sss/depts/economics/ef_staff/johnhunter

Natalia Isachenkova

Kingston Business School ( email )

Kingston Hill
Kingston upon Thames
Surrey KT2 7LB
United Kingdom

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