AISSMS IOM - Does Altman Z-SCORE MODEL Accurately Predict Bankruptcy?

There are various ways to assess financial condition of a firm. Choice of financial technique depends upon the purpose for which the assessment activity is done. It aims at achieving right level of complexity to decipher right kind of information for firm’s stakeholders. It may be for any of the stakeholders of the firm – business and corporate manager; sponsors and financial institution; investors; and prospective employees.

Financial ratios are the most extensively used tools for trend analysis, cross-sectional analysis and comparative analysis; and are categorized under various indicators. In the Indian context also, many researchers have developed various models to predict bankruptcy in various sectors. These analyses are still evolving and due to lack of availability of data of the distressed companies, the empirical study and its analysis is still a challenge.

  

The discriminant function, of the form Z = V1X1 + V2X2 + V3X3 + ……… + VnXn transforms the individual values to a single discriminate score or Z value.

Where, Vn = discriminant coefficient and Xn = independent variables.

Hence combination of ratios can be analysed together in order to remove possible ambiguities and misclassifications observed in traditional ratio studies.

Components used in the model:-

Original Z-Score model (Altman, 1968) for public firms classified the variables into five standard categories: liquidity, profitability, leverage, solvency and activity. From initial list of 22 indicators, Altman chose 5 because they could predict corporate health very well.

Z = 0.012 X1 + 0.014 X2 + 0.033 X3 + 0.006 X4 + 0.999 X5

Where,

X1 – working capital over total assets (WC/ TA)

Working capital to total assets ratio measures firm’s liquid assets compared to its size.

X2 ­– retained earnings over total assets (RE/ TA)

Conclusion:-

Emerging markets are trying to positively transform into a sustainable economic growth economies through trade, technology transfers and foreign direct investments. (READ FULL ARTICLE) Use of various forms of Z- Scores can early warn banks and investors about financial status of a firm. It can forewarn investors and lenders to reassess magnitude of default premium they require for bearing the risk of being attached to risky and distressed firms and help them secure their investment.