Estimate bankruptcy risk? Look beyond the annual balance!

Which customers are a threat and can go bankrupt in the short term? It is a question that every company struggles with. Studies have long shown that the traditional balance sheet analysis is not sufficient to correctly assess the risk of bankruptcy. Criteria such as liquidity, solvency and profitability are not good predictors of an impending financial downfall.

Business executives who want to get an idea of ​​the financial health of their clients usually look at the latest published annual balance sheet. 

The signals they get from those figures, however, say little about the risk of bankruptcy. This is evident in black and white from the Health Barometer of the Belgian Enterprises.

In this annual study, developed by Graydon and the Union of Judges in Commercial Affairs of Belgium (URHB), all data on Belgian bankruptcies is collected and examined. A total of 13 flashing lights or alarm values ​​were investigated and for each flashing light percentage chance that the company will go bankrupt within the year was calculated

Liquidity, solvency and profitability

Liquidity – 1 in 43

Liquidity is a good example of such a flashing light. Suppose you do not want to cooperate with customers who have a liquidity of 0.5 or less. This seems logical. 

After all, it means that the company has twice as much debt than short-term income. What does the study show? Of the 43 companies that, according to their latest financial statements, had this problem, only one effectively went bankrupt in 2016. So if you use this criterion to filter customers, you miss out on a lot of profit opportunities. In 42 out of 43 cases you throw away potential sales.

Solvency – 1 in 35

Another commonly used criterion is solvency. The study looks at the flashing light ‘solvency below zero’. These are companies with a negative equity that are in urgent need of fresh capital. Surprisingly, only one in 35 companies with this characteristic went bankrupt in 2016.

Profitability – 1 in 49

What about the profitability criterion? Profit is the engine for healthy growth. A company that does not make a profit will sooner or later sink. But what does the research say? 

The flashing light is activated if a company records a loss for both the operating result and the net result two consecutive financial years. In 2016, 7.8% of Belgian companies were in this leaky boat. However, this did not necessarily lead to a shipwreck. Because only one in 49 companies in this group was declared bankrupt.

Sophisticated score models

It is clear that these rough financial parameters have little predictive value. The financial statement alone does not tell the complete truth.

You need more sophisticated instruments to calculate the real financial risks. Instruments that take into account both financial and non-financial parameters. Such as the multi-score and other score models that Graydon developed. Moreover, it is never a good idea to be guided by one isolated signal. 

The Graydon models therefore always work with combinations of different signals, with each signal receiving a weighted value. These score models are the result of years of research and data mining. Moreover, they are continuously tested and adapted to the dynamic, economic reality.

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