Evaluation of credit risk based on firm performance

In this paper we investigate whether technical efficiency is an important ex-ante predictor of business failure. We use samples of French textiles, wood, and R&D companies to obtain efficiency estimates for individual firms in each industry. These efficiency measures are derived from a directional technology distance function constructed empirically using non-parametric Data Envelopment Analysis (DEA) methods. We summarize the effect of efficiency on the likelihood of default in terms of the franchise value hypothesis which states that more efficient firms will be less likely to fail. Estimating probit and logit regression models we find that efficiency has significant explanatory power in predicting the likelihood of default over and above the effect of standard financial indicators. Our empirical analysis also shows that caution needs to exercised when using the solvency ratio as an ex ante predictor of business failure. JEL Classification: G21