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The concept of crisis evolution is still not fully understood, despite over 40 years of research into investigations in the field of crisis and insolvency prediction. This is due to the fact that the financial situation of a firm changes within an unobservable life cycle continuum, comprising different economic states which are not in fact properly defined. The aim of this study was to contribute towards a better understanding of the differences between solvent and insolvent firms for the periods of one and two years prior to insolvency respectively. Through the application of correlation and factor analysis, an attempt was made to detect behavioral patterns in accounting ratios, which can in turn explain differences and similarities between the two groups of firms. The results of this study show that although accounting ratios from two consecutive years had low correlations for both groups of firms, they were much higher for insolvent firms. This provides evidence that the economic and financial situation of insolvent firms is much more dependent on its history when compared to solvent firms. Moreover, there is evidence to suggest that the change of the economic and financial situation of insolvent firms within the life cycle continuum tends to follow a predetermined path, in contrast to the more random nature of a solvent firm’s behavior. Additionally, the results showed that the factor loadings for solvent and insolvent firms differ for both observation periods, indicating that there are different underlying factors affecting the final outcomes for the two groups of firms. This is mainly attributable to disturbances in the scaling factors of total assets for both observation periods, as well as the disappearing size factor for the pre-distress year for insolvent firms, based on factor analysis.

Analysis of Correlational Behavior of Solvent and Insolvent Firms Based on Accounting Ratios