A STUDY OF APPLICATION OF ALTMAN Z SCORE MODEL FOR OMAN CEMENT COMPANY (SAOG), SOHAR SULTANATE OF OMAN Dr. RIYAS. KALATHINKAL 1 MUHAMMAD IMTHIYAZ AHMED 2 1&2 Faculty, Department of Business Studies, Shinas College of Technology, Ministry of Manpower, Sultanate of Oman ABSTRACT Businesses are enterprises which produce goods or render services for profit motive. To be able to predict the financial soundness of a business has led to many research works. Financial ratios are a key indicator of financial soundness of a business. Financial ratios are a tool to determine the operational & financial efficiency of business undertakings. There exist a large number of ratios propounded by various authors. Altman developed a z-score model ratios as its foundation. The Altman Z-score is based on five financial ratios that can be calculated from data found on a company's annual report. The Altman Z-score can be used to evaluate corporate credit risk. Altman Z Score is a tool for data analysis, programmed to predict the quick financial assessment. The Altman Z-score in practice uses multiple business income and balance sheet values to evaluate the financial health of a company. The estimation was originally based on data from publicly held manufacturer, but has since been re-estimated based on other data sets for private manufacturing, non-manufacturing and service companies. This study lays emphasis on the Application of Altman Z Score Model for Oman Cement Company. Key words: Altman Z Score, Financial ratios, Bankruptcy, Oman Cement Company. 1. INTRODUCTION Business is any undertaking working towards profit objective. Predicting if a Business will do well or go bankrupt, before they actually do has led to propagation of various theories. It is fascinating for researchers to predict in advance if a business will be able to meet its obligation or will dissolve. Business failure has led to many studies of bankruptcy prediction. Business failure as discussed by some leading authors is discussed below. Fitzpatrick (1932) identified five stages leading to business failure. They are (1) incubation (2) financial embarrassment, (3) financial insolvency, (4) total insolvency, and (5) confirmed insolvency. Incubation is when the company s financials are just developing. Financial embarrassment is when management becomes aware of the firm s distressed condition. Financial insolvency occurs when the firm is unable to acquire the necessary funds to meet its obligations. Total insolvency occurs when the liabilities exceed the physical assets. Finally, confirmed insolvency occurs when legal steps are taken to protect the firm s creditors or liquidation occurs. (Poston, Harmon, & Gramlich, 1994) Karels and Prakash (1987) mentioned that a diverse set of definitions has emerged to explain business failure. The set includes negative net-worth, non- payments of creditors, bond defaults, inability to pay debts, over drawn bank accounts, omission of preferred dividends, receivership, etc. Aharony, Jones, and swary (1980) describe business failure as an indication of resources misallocation that is undesirable from a social point of view. Altman s 1968 original Z-score has evolved from the failings of the univariate analysis to being used with more modern methods such as neural networks. www.icmrr.org 16 icmrrjournal@gmail.com
2. PROFILE OF OMAN CEMENT COMPANY (SAOG) It was formed in 1978. Rusayl Cement plant was completed in 1983 with an annual integrated cement production capacity of 624,000 tons, of Ordinary Portland Cement and Sulphate Resistent Cement. In 1999 clinkering capacity expanded to a total of 1.2 million MTs per annum. The second production line came on stream in mid 1998. Presently the company is working on expanding the capacity of plant form 1.26 MTS per annum to 1.70 MTS per annum by upgrading production line No. 1 and No. 2. Basic raw material quarries representing 98% of the raw mix viz. Limestone and Silica deposits, are in abundance in the pant's vicinity to last over 100 years. Oman Cement has a range of top quality products to meet your requirements. It has given a list of our products below with detailed description and specification data. 1. Sulphate Resistant Cement 2. Ordinary Portland Cement 3. Moderate sulphate resistant cement 4. Oil Well Cement The Company's shares are listed in the Muscat Securities Market as well as the Bahrain Stock Exchange. This study applies the most well-known of models, the Z-Score, through an application to Oman Cement Company. 3. OBJECTIVE OF THE STUDY The objectives of this study are to: 1. To highlight about Altman Z score model and how it is useful for Oman Cement Company to determine its solvency. 2. To analyze the financial statements of OMAN CEMENT COMPANY during the period 2009-2013 by using Altman Z score model. 4. THEORETICAL FRAME WORK In 1968, Edward Altman published what has become the best known predictor of bankruptcy. This predictor is a statistical model that combines five financial ratios to produce a product called a Z-score. The model has proven to be a dependable instrument in forecasting failure in a diverse mix of business entities. Dr. Altman s original model is calculated as: Z= 0.012X1+0.014X2+0.033X3+0.006X4+0.999X Working capital/total assets (X₁) is a measure of liquid assets in relation to the firm s size. The difference between current assets and current liabilities represents working capital. The current assets of a firm include cash on hand, accounts receivable, and inventories; the latter two assets are considered current, if cash conversion is expected within an operating cycle of a business. Current liabilities consist of the firm s financial obligations-short-term debt and accounts payable which will be met during the operating cycle. A positive working capital indicates a firm s ability to pay its bills. A business entity with a negative working capital will experience difficulty meeting its obligations. Altman s research finds this ratio to be more helpful than other liquidity ratios, such as the current ratio or the quick ratio. (Altman, 2000; Chuvakhin & Germania, 2003) Retained earnings/total assets (X2) represent a measure of cumulative profitability reflecting the firm s age as well as its earning power. A history of profitable operations and reduced debt is signified by firms that retain earnings or reinvest operational profits. Low retained earnings may indicate a www.icmrr.org 17 icmrrjournal@gmail.com
poor business year or reduced longevity for the firm. According to Dun and Bradstreet, 50% of businesses fail within the first five years of operation (Altman, 2000, 2002). A measure of an organization s operating efficiency separated from any leverage effects is a true depiction of asset production. Represented as earnings before interest and taxes/total assets (X3), this ratio estimates that cash supply available for allocation to creditors, the government, and shareholders. Altman (2000) classifies the ratio as a superior measure of profitability that is better than cash flow. Altman (2000, 2002) defines the market value of equity, or market capitalization, as a summation of both preferred and common stock or market value of equity/book value of total debt (X4). The stock market, the primary estimator of a firm s worth, suggests that price changes may foreshadow pending problems if a firm s liabilities exceed its assets. Altman believes this ratio is a more effective financial distress predictor than net worth/total debt (book values) The next ratio, sales/total assets (X5) signifies a standard turnover measure that unfortunately varies from one industry to another. Yet, the ratio is an indicator of a firm s efficient use of assets to create sales (Chuvakhin & Gertmenian, 2003). Altman (2000) has defined this as one measure of management s capacity in dealing with competitive conditions (p.22). Finally, Eidleman (1995) explains the applicability of the previously discussed ratios. Specifically, Eidleman states Each of these ratios is multiplied by a predetermined weight factor, and the results are added together. The final number the z-score will yield a number between -4 and +8. Scores that add to a z-score<1.81 have a high probability of bankruptcy, while scores>2.67 represent financial soundness. The gray area or zone of ignorance exists when firms have z-scores between 1.81 and 2.67 (Eidleman, 1995, pg.3-5). Altman s pioneer study is based on a sample of 66 publicly traded, manufacturing firms. Thirty-three of the firms had filed for bankruptcy and all had assets over $1 million. His model correctly predicts financial failure for 95% of the firms, one year prior to their demise. Accuracy decreases to 72% two years out and to 52% three years prior to insolvency (Altman, 1968). Type I errors, those that predict a bankruptcy that does not occur, are shown for 6% of the firms analyzed. Type II errors also were shown for 6% of the firms analyzed. Type II errors predict a solvent firm that files bankruptcy (Altman, 1993). In 1983, Altman developed a revised Z-score model for privately held firms. Credit analysis, private placement dealers, accounting auditors, and firms themselves are concerned that the original model is only applicable to publicly traded entities (since X4requires stock2 price data) (Altman, 1993, p.202). The revised Z-scores substitute the book value of equity for the market value in X4. The new Z-score model ratios are listed below: X4= A change in the weight factor is also calculated. The revised Z-score formula follows Z= 0.717(X1) +0.847(X2) + 3.107(X3) +0.420(X4) + 0.998(X5) Cut off scores are also adjusted so that scores of <1.23 indicate bankrupt firms and scores of >2.90 are indicators of non bankrupt firms. Firms with scores between 1.23 and 2.90 are determined to exist in the grey area or zone of ignorance (Altman, 1993). Altman s new sample produces similar results as the original Z-score model, indicating 90.9% accuracy in bankruptcy forecasting at least one year prior to actual failure. Firms with scores over 2.90 have a 97% chance of continuing operations with financial health (Altman, 1993). www.icmrr.org 18 icmrrjournal@gmail.com
5. SCOPE OF THE STUDY 1. The scope the study will be about Altman Z score model and how it is useful for Oman Cement Company (SAOG) to determine the solvency of the company. 2. This study will check if the company is in good position or it will face bankruptcy. 3. The study will cover a period of five years from 2009 to 2013 by referring the financial statement, balance sheet and income statement for analysis. 6. PERIOD OF STUDY The study will cover a period of five years starting from 200 to 2013. 7. RESEARCH METHODOLOGY The research methodology that will be used to collect information for this study is secondary by collecting information through books, articles, related information from websites and by using the financial statement of the Oman Cement Company (SAOG) to find whether the company is in the position of bankruptcy or not. 7 (i). Data used for study Data that will be use in this study are mainly secondary such as annual report of Oman Cement Company. 7 (ii). Research design Collected data from annual reports of Oman cement is mainly to make comparison of data from 2009 to 2013 and to see how the Altman Z score model is applied in the company. 7 (iii). Tools for analysis The tools that are used in this study are: Altman Z score model: Z-score model ratios are listed below: X4= Z-score formula follows Z= 0.717(X 1) +0.847(X 2) + 3.107(X 3) +0.420(X 4) + 0.998(X 5) Cut off scores are also adjusted so that scores of <1.23 indicate bankrupt firms and scores of >2.90 are indicators of non bankrupt firms. Firms with scores between 1.23 and 2.90 are determined to exist in the grey area or zone of ignorance Now that we know the formula, it's helpful to examine why these particular ratios are included. Let's take a look at the significance of each one in the analysis of data section: www.icmrr.org 19 icmrrjournal@gmail.com
8. ANALYSIS OF DATA In order to analyze and understand the financial health of the company the following formula is used. The following is the formula for Altman Z-score: Z= 0.717(X1) +0.847(X2) + 3.107(X3) +0.420(X4) + 0.998(X5) Cut off scores are also adjusted so that scores of <1.23 indicate bankrupt firms and scores of >2.90 are indicators of non bankrupt firms. Firms with scores between 1.23 and 2.90 are determined to exist in the grey area or zone of ignorance The Altman Z-score is based on five financial ratios that can be calculated from data found on a company annual report. 8.1 Working capital / total assets(x1): Table 1 -TABLE SHOWING CALCULATION OF WORKING CAPITAL Year Current Assets Current Liabilities Working Capital 2009 24,186,783 8,451,467 15,735,316 2010 40,515,044 12,595,728 27,919,316 2011 42,005,074 14,470,549 27,534,525 2012 37,088,170 11,728,884 25,359,286 2013 47,003,084 14,033,560 32,969,524 Source: Annual report Table 2 - WORKING CAPITAL TO TOTAL ASSETS (X1) Year Working capital Total assets X1 2009 15,735,316 132987025 0.12 2010 27,919,316 172247578 0.16 2011 27,534,525 174309109 0.16 2012 25,359,286 185059514 0.14 2013 32,969,524 192763104 0.17 Source: Annual report Figure 1 - WORKING CAPITAL / TOTAL ASSETS Source: compiled from Table No 2 www.icmrr.org 20 icmrrjournal@gmail.com
Inferences: INTERCONTINENTAL JOURNAL OF FINANCE RESEARCH REVIEW From the Table No.2 and figure No.1 during 2009-2013 the WC/TA varies up and down. The company during the year 2009 to 2013 has positive working capital. The company has not experienced any problem in meeting its short-term obligations because; it simply had enough current assets to cover those obligations. Company has enough short term assets to cover its short term debt in these periods. In 2009 it shows increase that means company has functioned well. In 2010 it is decreased little bit in 2012 it continues to decrease but in 2013 it was highest. 8.2 Retained earnings to total assets 0.46 0.45 0.44 0.43 0.42 0.41 0.4 Table 3 RETAINED EARNINGS TO TOTAL ASSETS Year Retained earnings Total assets X2 2009 60,217,974 132,987,025 0.453 2010 73,013,440 172,247,578 0.424 2011 73,570,285 174,309,109 0.422 2012 81,155,509 185,059,514 0.439 2013 85,595,171 192,763,104 0.444 Source: Annual report Figure No 2 RETAINED EARNINGS TO TOTAL ASSETS X2 2009 2010 2011 2012 2013 X2 Source: compiled from Table No 3 Inferences: From the above Table and figure during 2009-2013 the retained earnings to total asset of the company has high RE/TA it means that it has a history of profitability and the ability to stand up to a bad year of losses. The best performance was in the year 2009. As we see it was decreased in 2010 and 2011 but again it was increased in 2012 and 2013. 8.3 EBIT to Total Assets www.icmrr.org 21 icmrrjournal@gmail.com
4 3 2 1 0 Table No. 4 - EBIT TO TOTAL ASSETS Year EBIT Total Assets X3 2009 28,377,799 8451467 3.36 2010 29,540,226 12595728 2.35 2011 16,065,465 14470549 1.11 2012 20,932,019 11728884 1.78 2013 19201278 14033560 1.37 Source: Annual report Figure 4 - EBIT TO TOTAL ASSETS 2009 2010 2011 2012 2013 Source: compiled from Table No 4 Inference: INTERCONTINENTAL JOURNAL OF FINANCE RESEARCH REVIEW From the above Table and figure during the year 2009 to 2013 it shows the EBIT to total assets and this ratio is effective way of assessing a firm's ability to squeeze profits from its assets before factors like interest and taxes are deducted. In 2009 it show highest ratio which means the company has earned more in that year and lowest ratio was in 2011. 8.4 Market Value of Equity to Total Liabilities Market Value of Equity It is obtained by multiplying the number of its outstanding shares by the current share price. Market value of equity = share value number of its outstanding shares The calculation be in table 5 Table 5 MARKET VALUE OF EQUITY Year Share No. of Market value value outstanding share of equity 2009 0.747 330,872,710.00 247161914.4 2010 0.64 330,872,710.00 211758534.4 2011 0.432 330,872,710.00 142,937,010.72 2012 0.639 330,872,710.00 211427661.7 2013 0.816 330,872,710.00 269992131.4 Source: Annual Report Market Value of Equity to Total Liabilities Market To get market value of equity to total liabilities we use this formula: X4= Ratio www.icmrr.org 22 icmrrjournal@gmail.com
The calculation is in Table 5 Figure 5 MARKET VALUE OF EQUITY TO TOTAL LIABILITIES MARKET 15 X4 10 5 0 2009 2010 2011 2012 2013 X4 Source: compiled from table No.5 Inferences: From the above Table and figure during the year 2009 to 2013 the company has not become insolvent because the company's market value increased before its liabilities and exceeded its assets on the financial statements. It is right the liabilities were increased year by year but the market value of equity is more than its total liabilities. In the first year the ratio was very high. It was 14.09042046 the second and third year 2010, 2011 it was decreased but in 2012 it went up by more than 5 and also in 2013 it continuous to increase by more than 8 in ratio. 8.5 Sales to Total Assets To get X5 we use this formal The calculation is in Table No.7 Table 7 - SALES TO TOTAL ASSETS Year Net sales Total assets X5 2009 68,284,005 132987025 0.513 2010 51,879,345 172247578 0.301 2011 47,912,767 174309109 0.275 2012 56,658,112 185059514 0.306 2013 32422521 192763104 0.168 Source: Annual Report www.icmrr.org 23 icmrrjournal@gmail.com
Figure 6 - SALES TO TOTAL ASSETS 0.6 0.5 0.4 0.3 0.2 0.1 0 2009 2010 2011 2012 2013 ratio Source: compiled from Table No.7 Inferences: From the above Table and figure during the year 2009-2013. In 2009 it was highest ratio that means from 2009 to 2013 the company's best performance is in the year 2009. In 2010 it started to decrease. In 2010 and 2012 it has same ratio 0.3. In 2013 it shows high decrease the company should take care to not become insolvent as per the above analysis. 9. COMPUTING Z SCORE After we get each X in this part we compute Z-score by using this formula: Z= 0.717(X1) +0.847(X2) + 3.107(X3) +0.420(X4) + 0.998(X5) The calculation be in Table8 Table 8 - COMPUTING Z SCORE YEAR 0.717(X1) 0.847(X2) 3.107(X3) 0.420(X4) 0.998(X5) Z-score 2009 0.08 0.383530829 10.43248722 5.917488526 0.512437 17.33 2010 0.12 0.359031949 7.286715161 3.748309544 0.300588 11.81 2011 0.11 0.357491538 3.449447547 2.315959219 0.274323 6.51 2012 0.10 0.371441136 5.544925078 3.282092476 0.305549 9.60 2013 0.12 0.376104702 4.25112165 3.889291726 0.167862 8.81 Source: Compiled from tables Figure 7 - COMPUTING Z SCORE 20 15 10 5 0 Z-score 2009 2010 2011 2012 2013 Z-score Source: compiled from table No. 8 www.icmrr.org 24 icmrrjournal@gmail.com
Inference: From the above Table and figure during 2009 to 2013. The scores are more than 2.90 that mean the company is not affected by bankruptcy. Minimal ratio was in 2011 but that doesn t mean company faced bankrupt to face bankrupt it should be less than 1.23 and it was more than it by 5.28. 10. FINDINGS 1. The Working Capital to Total Assets ratio during 2009 to 2013 has positive working capital. In 2010 it is decreased little bit in 2012, it continues to decrease but in 2013 it was the highest. 2. During the year 2009 to 2013 the retained earnings to total asset of OMAN CEMENT COMPANY shows its best performance in 2009. As we see it was increased in next year. In 2010 and 2011 but again increased in 2012 and 2013. 3. The Earnings before Interest and Tax to Total Assets of OMAN CEMENT COMPANY in 2009 it shows highest ratio, which means the company earns more and the lowest ratio was in 2011. 4. The market value of equity to total liabilities ratio in 2009 was very high. In 2010 and 2011 it was decreased, but in 2012 and 2013 it went up by more than 2. 5. The Net Sales of OMAN CEMENT COMPANY in 2009 was higher; it means from 2009 to 2013 the company's best performance was identified in the year 2009. In 2010 and 2012 it was 0.3. In 2013 it shows high decrease in net sales. 6. During 2009-2013 the company's Z score was more than 2.90 therefore it is understood that the company is not affected by bankrupt. Minimal ratio was identified in 2011, but still the company did not face any bankruptcy issues. To face bankruptcy it should be less than 1.23 and it was more than 5.28. This indicates that the company's financial position is sound. 11. RECOMMENDATIONS 1. The company has to be cautious; if their current liability exceeds current assets else it will lead to bankruptcy. 2. The company may increase its retained earnings to be more profitable. Less profitability would be expected to be associated with an increased risk of insolvency. 3. It can also increase its earnings before interest and taxes to be more productivity. Higher productivity is expected to be associated with a healthy firm. 4. The company may increase it sales because lower sales would be expected to be associated with unhealthy prospects for a firm 5. The company may increase market value of equity more than its liabilities to avoid bankrupt. 12. CONCLUSION The Altman s Z score is one of the best known, statistically derived predictive models used to forecast a firm s impending bankruptcy. The testing of the Z-score model has been an interesting and challenging experience. In many situations the model can be a very useful tool for getting an indication whether a firm may face financial. There is reason to believe that the Z-score model have gained popularity much due to the fact of its simplicity and cost-efficiency. The model does not require the user to have extensive knowledge in advanced finance for him or her to understand how the model functions and moreover how to actually apply it. Even though Altman s bankruptcy prediction model is the most popular analytical tool utilized by investors, auditors, and stakeholders, Altman advises not to use his formula to the exclusion of other analytical techniques (Altman, 1993). In Conclusion, Altman s revised Z-score model is one of the most effective Multiple Discriminate Analysis, which has been researched throughout the last 40 years. Altman s www.icmrr.org 25 icmrrjournal@gmail.com
Model has being used in various industries to predict bankruptcy. We have used Altman s Z score model OMAN CEMENT COMPANY to predict if the business will have a downfall. The outcome of the study reveals that the company is in good position and it is not faced any bankruptcy issues. 13. REFERENCE 1. http://en.wikipedia.org/wiki/altman_z-score 2. http://www.readyratios.com/reference/analysis/ 3. Altman, Edward I. (July 2000). "Predicting Financial Distress of Companies". Retrieved on September 4th, 2009 from http://pages.stern.nyu.edu/~ealtman/zscores.pdf 4. Altman, Edward I. (September 1968). "Financial Ratios, Discriminate Analysis and the Prediction of Corporate Bankruptcy". Journal of Finance: 189 209 5. Altman, Edward I. (May 2002). "Revisiting Credit Scoring Models in a Basel II Environment". Prepared for "Credit Rating: Methodologies, Rationale, and Default Risk", London Risk Books 2002. 6. www.portfolio123.com 7. onlinelibrary.wiley.com www.icmrr.org 26 icmrrjournal@gmail.com