In this paper a latent class model (LCM) is applied to estimate corporate bankruptcy and insolvency risk in Australia using a number of financial, market and macro-economic variables and indicators. LCMs represent a significant improvement on traditional techniques such as standard logit and linear discriminant analysis because they relax the highly restrictive IID condition which can distort parameter estimates and potentially undermine predictive accuracy (Jones and Hensher, 2004).
While LCMs are more general (powerful) than standard approaches, they differ from many other non-IID approaches in that they are relatively straight forward to estimate and interpret. In this study we demonstrate the application and interpretation of LCM models based on a large sample of corporate failures in Australia. We also consider the potential of LCMs for future research and practice in this field.
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