In the following, we validate the assumption made for the construction of PNBE that negative book equity is a good indicator of bankruptcy in the sense that the book equity of bankrupt firms diminishes in the years before bankruptcy and is finally depleted by losses in the year of bankruptcy. Table 2.3 reports the means of the variables related to book equity and earnings for bankrupt firms as well as for firms that never became bankrupt. For
bankrupt firms, we provide statistics for each of the five years preceding bankruptcy and for the year of bankruptcy. For example, year -1 denotes the year one year before bankruptcy and year 0 denotes the year of bankruptcy. To avoid confounding effects from changes in the sample, we analyze only those 739 bankrupt firms for which we have at least five years of data before their bankruptcy.14 Of these firms, only 300 also present a
balance sheet in the year of their bankruptcy. For comparison we report the statistics for the non-bankrupt firms (corresponding to another 168,297 firm-years).
Table 2.3 Evolution of book equity and earnings in the years around bankruptcy Bankrupt Firms
Non- bankrupt
Firms Years Relative to Bankruptcy
Variable -5 -4 -3 -2 -1 0 PNBEt 0.12 0.13 0.15 0.22 0.41 0.61 0.10 BkEqt 215.00 223.21 198.44 171.59 82.75 -90.07 759.28 BkEqt/AssTt 0.40 0.38 0.33 0.25 0.03 -0.27 0.48 NegBEt 0.04 0.05 0.07 0.12 0.29 0.55 0.03 Earnt -0.85 -19.46 -22.92 -45.85 -99.25 -245.63 49.17 Earnt/AssTt -0.09 -0.10 -0.10 -0.18 -0.37 -0.52 -0.14 NegEt 0.45 0.49 0.56 0.73 0.89 0.89 0.33 N 739 739 739 739 739 300 168,297
This table reports the summary statistics of bankrupt firms and of firms that never became bankrupt, respectively. For bankrupt firms, we report statistics in the last five years before bankruptcy and in the year after bankruptcy to see the evolution. We only include those bankrupt firms with a history of at least five years before bankruptcy to ensure that we investigate the same firms over time. For non- bankrupt firms, we report statistics for all observations. The variables ($ millions for all the values except the dummy variables and probability values) are the following: PNBE is the probability that losses deplete current book equity, BkEq is book equity, BkEq/AssT is book equity divided by total assets, NegBE is a dummy for negative book equity, Earn is the change in retained earnings, Earn/AssT is the change in retained earnings divided by total assets, and NegE is a dummy for negative earnings. All the variables (except the indicator variables and probability values) are winsorized annually at the 1st and 99th percentiles. The sample period is from 1968 to 2013.
Quantities are reported for those observations for which all the variables are available.
For the non-bankrupt firms, we observe a negative book equity only in 3.0% of the firm-years. In contrast, even five years before bankruptcy, 4% of bankrupt firms already have negative book equity. This ratio increases monotonically to 29% in year -1, directly before bankruptcy. Finally, 55% of bankrupt firms have negative book equity in the year in which they go bankrupt (year 0). Note, however, that out of the 739 bankrupt firms only
14 This restriction is only made for this analysis; all other analyses also include bankrupt firms with a history
300 are able to present financial statements at that time. Presumably, the situation of the others is even worse, so that the ratio over all bankrupt firms would be even higher. Accordingly, average book equity five years before bankruptcy is 215.00, which is already much smaller than the average of firms that never go bankrupt (759.28). The average book equity for bankrupt firms consistently declines from year -4 on, with the most severe fall from 171.59 in year -2 to 82.75 in year -1. In the year of bankruptcy, average book equity is negative (-90.07). Note that standardizing book equity by total assets does not change the tenor of our observations. Thus, our results confirm that a low book equity is a signifier of bankruptcy even five years before bankruptcy.
Moreover, we find a similar pattern for earnings: Only 33% of non-bankrupt firm- years report negative earnings. In contrast, the ratio of bankrupt firms with negative earnings rises from 45% in year -5 to 89% in year -1. The mean earnings five years before bankruptcy is -0.85, already much smaller than the mean of firms that never become bankrupt (49.17). Average earnings for bankrupt firms show a downward trend from year - 5 on and experience the most significant fall from -45.85 in year -2 to -99.25 in year -1. In the year of bankruptcy, average earnings are -245.63 and thus even more negative. Similar results apply to the mean of earnings standardized by total assets. Importantly, average losses in the year before bankruptcy (-99.25) deplete average book equity in the year of bankruptcy (82.75).
On average, our PNBE is monotonically increasing during the years before bankruptcy. In year -5, the mean of the PNBE is 11.7%, which is already higher than the average PNBE of non-bankrupt firm-years (10.0%). In year -2, the PNBE of bankrupt firms is 22.3% and in the year before bankruptcy, it jumps to 41.2% and finally to 60.6% in the year of bankruptcy.
These results strongly support our overall assumption that book equity diminishes in the years before bankruptcy and finally turns negative after bankruptcy. This depletion of book equity is explained by earnings that are negative even five years before bankruptcy and a further decrease in the years preceding bankruptcy. Book equity and earnings experience a dramatic fall, and losses exceed book equity in the year directly before bankruptcy. Accordingly, our variable of the PNBE, which also incorporates the volatility of the earnings estimate, consistently rises during the years before bankruptcy. By this, we find differences between healthy and bankrupt firms already five years before the latter
firms go into bankruptcy. That is, diminishing book equity and weak earnings are early warning signals for an impending bankruptcy. It may be somewhat surprising that we find such a relation between book equity and bankruptcy for U.S. firms even though the U.S. bankruptcy law does not require firms to file for bankruptcy when assets fall below liabilities. Therefore, further research should be devoted to the question whether this relation is even stronger in countries whose law explicitly defines negative book equity to trigger a bankruptcy filing.