Recovery Candidates and Turnaround Strategies

Abstract

Research into the prediction of corporate failure has produced useful predictive univariate and multivariate financial ratio models. These models have been shown to predict accurately corporate failure in that very few companies fail without having first being identified as failure candidates. However, the preoccupation of these models with minimising Type I errors (misclassification of failed companies, the more costly of the two errors) results in a high number of Type II errors (misclassification of non-failed companies). These Type II errors would include those financially distressed companies that enact a financial turnaround but are classified as failure candidates. Drawing upon variables cited in the turnaround literature, this study explores whether information contained within annual reports is useful in distinguishing between distressed companies that enact a turnaround and those that fail. This study develops a discriminant model to identify distressed companies that have turnaround potential. Analysis of the results reveals that successful turnarounds are associated with the severity of the distressed state, its determinants, with the extent of change in the distressed state since the previous year, and with firm size.