Assignment 1 : Corporate Failure Prediction Models

The Altman ZETA/Z-Score Model :

Corporate Failure Prediction:

The ability to foreseeably diagnose a corporate entitys demise before it occurs (ex -ante) or to discriminate appropriately in hindsight is referred to as corporate failure prediction. It is of interest to numerous researchers and experts in the fields of accountancy, corporate governance and finance, due to its tremendous impact on the stances and affairs of numerous stakeholders and entities that can be prospectively affected by such occurrence. These include: Lenders : For Debt collection purposes and for security (Credit Risk minimization) Investors: For monitoring stock Price return maximization and risk management purposes (impact on Portfolio etc...) Regulatory authorities: for prevention and identification of potential causative agents of systemic cataclysms and systemic risk mitigation especially in the case of TBTF and TITF entities. To prevent the stability of the countrys financial system as a whole and the integral reputation of the Regulator. Governmental Bodies and entities: Corporate failures are not only causative agents of systemic calamities that might affect the fiscal stance with respect to preventative expenditure but also negatively impact the governmental fiscal stance with respect to its taxation revenue. Auditors and Assurance Agencies: Such models can help auditors and other assurance or even insurance practitioners check if such entities are still a going concern: i.e. the ability of a business or entity to continue operating in the foreseeable future. Management and Corporate governance entities: Executives do not only get salaries, but also shares. Therefore there exists a process of earnings management. This creates an incentive for better stewardship accounting, therefore the better we perform the more shares we get. Accounting standards and practices namely affected by this include IAS 19 (employee benefits) and IFRS 2: Share paid executive parties.

Models Designated at Corporate Failure Prediction: Extant and pioneering literature that deal with corporate failure prediction models includes the work of William Beaver (1966), concerning the application of student t-test statistics to select accounting ratios of a sample of firms providing the first basis of univariate analysis. Together with the works of Edward l. Altman applying linear multiple discriminant analysis (MDA) of a sample of 33 firms filing for Chapter X Bankruptcy petition from 19461966 and 33 firms which were randomly selected using random stratified sampling. This technique was embodied in the infamous ZETA and Z-score models developed by Altman (1973). Other Models developed throughout the years included logistic regression employed by Ohlson (1980) and iterative models employing techniques of recursive partitioning. It is crucial to differentiate amongst positive and normative theories of corporate failure and the resultant explanatory models. Normative Accounting theories are ones which attempt to describe what the foreseeable financial future could be for an entity, which entail numerous subjective value judgments. On the other hand positive theories of corporate failure aim to create a predictive model, based on past data and statistical, qualitative and qualitative correlations, which are objective in nature and rely solely on past data for the basis of their predictive conclusions. It is crucial to note that all of the aforementioned models given the historic timeseries statistical methods employed, stem from positive accounting theory and are hence referred to as positive models of corporate failure. There exist univariate (focusing on one specific variable at a time), Multivariate (explaining causality by means of inter-correlations and relationships amongst a set of variables considered simultaneously) and iterative models ( applying recursive partitioning to search for a combination of weighted

Assignment 1 : Corporate Failure Prediction Models

explanatory variables which best discriminate amongst a priori categories.) to explain corporate failure, together with Early Warning and Case Studies. The Altman Z-Score Model. This model developed by Altman in 1968 makes use of linear multiple discriminant analysis to develop a more accurate and slightly more sophisticated model than conventional financial ratio analysis and their univariate mode of analysis. The inherent limitations of ratio analysis namely; lack of comparability, subjectivity and manipulation and the lack of universality and obsolescence of information led to the questioning of the relevance and applicability of Univariate financial ration analysis based works such as that of Beaver. Beaver found that a

number of indicators could discriminate between matched samples of failed and non-failed firms for as long as five years prior to failure. (Heine & Stern, 2000.)Therefore it was only the next logical step to utilize multivariate
discriminant analysis for corporate failure prediction models like such ; Altmans ZETA and Z-Score Model. The Mechanics of Multiple Discriminant Analysis (MDA). According to Altman, multiple discriminant analysis is utilized to predict and segregate in scenarios where there exist dependent variables of a qualitative nature with attributes such as (either/or , Yes/No A and B.). The preliminary step entails explicit identification of the classes of attributes of the data in our case the discriminative groups of Bankrupt vs. Non-Bankrupt entities. Each group naturally has what are termed to be discriminative attributes which differentiates one group from another. In the case of the Z-score certain combinations of values for the financial ratios in the Z-score model when multiplied by their respective multivariate coefficients enable this discrimination to become evident. Altman also ensues to describe the very workings of MDA :MDA in its

most simplest form attempts to derive a linear combination of these characteristics which best discriminates between these groups.(Altman, 1973). Therefore if quantitative data in respect of these discriminative attributes
can be obtained for the population or entire sample, then a set of discriminant coefficients can be determined by means of MDA. Multiplication of these coefficients by the respective ratios or discriminant attribute values yields the Z-score that classes the entity into one of the mutually exclusive groups i.e. in our case : Bankrupt vs. non bankrupt. Our linear multivariate discriminant model can therefore now take the following form :

Z = V1X1 + V2X2 + V3X3+ V4X4+ .V5X5

Where:V1,X2Vn.are the discriminant coefficients,

& : V1,X2,..Xnare the independent variables.

Therefore through devising the model, Altman finally conjured up the model :
Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + 0.999T5(Altman 1973)

where the independent variables where as follows :

T1 = Working Capital / Total Assets T2 = Retained Earnings / Total Assets (Return on Total Assets) T3 = Earnings Before Interest and Taxes / Total Assets T4 = Market Value of Equity / Total Liabilities (Book Value/ Total liabilities)

Assignment 1 : Corporate Failure Prediction Models

T5 = Sales/ Total Assets (Total Asset Turnover) Together with the preceding coefficients being the discriminant coefficients. The classification of the discriminant groups was determined to be as following:

Based on the Z-Score obtained a business is classified as : Safe (remote Probability of Bankruptcy applicable), Grey (Possible Probability of Bankruptcy) and Distressed or Bankrupt (Imminent Probability of Bankruptcy or Bankrupt.). Z >= 2.99 -Safe 1.81 =< Z =< 2.99 -Grey Z=< 1.81 -Distress

Application of the Altman ZETA Model to the financial Statements of Simonds FarsonsCisk Years Ending 31/01/2004 and 31/01/2013 respectively : The Application of the aforementioned model to the group consolidated financial statements of Simonds FarsonsCisk required making use of the groups consolidated financial statements to extract the figures involved in calculating the requested ratios as independent variables (X1.X5). Moreover for one particular ratio, the Book Value/ Total Liabilities, the market capitalization and the share price as at that stated time were needed. These were obtained from notes to the financial statements (Shareholders information) for both the respective years; the respective market share price was obtained from the Malta Stock Exchange equity charts database (www.borzamalta.com.mt). The market capitalization rate was calculated as the product of the current market share price and the number of shares outstanding. The final result of such analysis can be found in Figure 1.0 Results and Conclusive Report: For both the financial reporting periods 31/01/2004 and 31/01/2013, the group has obtained a Z-Score that categorically placed it in the Grey zone pertaining to the range (2.6>=Z=>1.81), implying a possible scenario of bankruptcy that has a probability of materializing. Nevertheless upon comparing both respective Z-scores, one can instantly see that the Z-score obtained in 2004 (2.25) is by far better than that obtained in 2013 (1.75). Referring to the ratios concerned in the model to attempt to explain such significant discrepancy in value, the predominant ratios that showed a gradual decline was the (working capital/total assets ratio) with a coefficient weighting of 1.2, the working capital of the group has decreased significantly, primarily due to a decrease in net receivables (Trade Receivables-Trade Payables) contributing to a difference of EUR 6934 in Working Capital from 2004 to 2013(adjusted for inflation and currency conversion.) One other ratio that evidenced considerable decline was the Total Asset turnover, with a weighting of approximately 1, this was primarily due to the decrease in total turnover in comparison to the total assets of the group. This reduction was primarily due to the negative impact of the removal of protectionist trade policies and practices that SFC benefited from in the years prior to Maltas accession to the EU on the 1st of May 2004. Consequentially due to said eventuality, Malta entered into the European Unions Common market with application of common EU external trade practices and policies. This resulted in the decline in total asset turnover of approximately 33%.

Assignment 1 : Corporate Failure Prediction Models