Advanced Accounting AY 2017/2018 Lesson 9 Predicting Financial Distress Università degli Studi di Trieste D.E.A.M.S. Paolo Altin 335
Predicting Financial Distress Financial ratios are often used to predict the future. Based on current or past performance. The analyst can influence the results: choice of ratios and interpretation of results depend on the judgement and opinion of the analyst. Researchers have shown an interest in the ability of ratios to predict the financial failure of a company. Financial failure: a business either being forced out of business or being severely adversely affected by its inability to meet its financial obligations. It is often referred to as going bust or going bankrupt. 336
Using single ratios Early research focused on the examination of ratios on an individual basis to see whether they were good or bad predictors of financial failure. A particular ratio (for example the current ratio) for a business that had failed was tracked over several years leading up to the date of the failure. Beaver: he carried out the first research in this area. He identified 79 businesses that had failed. He then calculated the average of various ratios for these 79 businesses (for ten years). Then he compared these average ratios with similarly derived ratios for a sample of 79 businesses that did not fail over this period. Beaver found that some ratios exhibited a marked difference between the failed and non-failed businesses for up to five years prior to failure. 337
Using single ratios 338
Using single ratios 339
Using combinations of ratios The approach adopted by Beaver is referred to as univariate analysis because it looks at one ratio at a time. It an produce interesting results but there are practical problems associated with its use. Researchers developed models that combine ratios in order to produce a single index that can be interpreted more clearly. Researchers used a multiple discriminate analysis (MDA). 340
Using combinations of ratios 341
Using combinations of ratios The boundary shown can be expressed in the form: where a is a constant and b and c are weights to be attached to each ratio. A weighted average or total score (Z) is then derived. The weights given to the two ratios will depend on the slope of the line and its absolute position. 342
Using combinations of ratios THE Z SCORE MODELS Altman was the first to develop a model (in September, 1968), using financial ratios, that was able to predict financial failure. In 2000 he revised that model. Altman s revised model, the Z score model, is based on five financial ratios and is as follows: Z = 0.717a + 0.847b + 3.107c + 0.420d + 0.998e Where: a = Working capital/total assets b = Accumulated retained profits/total assets c = Operating profit/total assets d = Book (balance sheet) value of ordinary and preference shares/total liabilities at book (balance sheet) value e = Sales revenue/total assets 343
Using combinations of ratios THE Z SCORE MODELS According to Altman, those businesses with a Z score of less than 1.20 tend to fail, and the lower the score the greater the probability of failure. Those with a Z score greater than 2.90 tend not to fail. Those businesses with a Z score between 1.23 and 4.14 occupied a zone of ignorance and were difficult to classify. However, the model was able overall to classify 91 per cent of the businesses correctly. Altman based his model on US businesses. 344