Financial distress pre-warning indicators: a case study on Italian listed companies

The reform of the Italian insolvency law in 2005 introduced the troubled debt restructuring (TDR) procedure as a means to restore companies that are in financial distress and avoid potential liquidation. The success of this procedure depends strictly on the timeliness of intervention. Therefore, the availability of a prediction tool appears to be crucial. This paper focuses on the ability of accounting ratios to predict the financial distress status of a firm as defined by the law. Based on a linear discriminant analysis, we formulate the probability of a firm filing for TDR in one year, as well as other quantitative techniques that are intended to monitor financial health. Specifically, we begin with a test of Altman’s Z, Z' and Z'' scores for bankruptcy on the listed Italian companies that filed for TDR in the period 2005–12. The test results do not completely satisfy the TDR prediction.We then introduce a new score formula based on seven accounting ratios and specific coefficients. Several confirmative analyses are also conducted to validate the predictive accuracy and the generalization power of our score formula.