“Several techniques have been developed to help in prediction why companies fail.” – Describe the Altman: Z Score Model in this regard.
The Z-Score model is a quantitative model developed by Edward Altman in 1968, to predict bankruptcy or financial distress of a business. The Z-score is a multi variate formula that measures the financial health of a company and predicts the probability of bankruptcy within 2years. This model involves the use of a specified set of financial ratios and a statistical method known as a Multiple Discriminant Analysis. (MDA). The real world application of the Altman score successfully predicted 72% of bankruptcies two years prior to their failure.
The model of Altman is based on a linear analysis in which five measures are objectively weighted and summed to arrive at an overall score that then becomes the basis for classification of companies into one of the two a priori groupings that is bankrupt or non-bankrupt. These five indicators were then used to derive a Z-Score. These ratios can be obtained from corporations‘ financial statements.
The five Z-score constituent ratios are:
(i) Working Capital/Total Assets (WC/TA):- a firm with negative working capital is likely to experience problems meeting its short-term obligations.
(ii) Retained Earnings/Total Assets: - Companies with this ratio high probably have a history of profitability and the ability to stand up to a bad year of losses.
(iii) Earnings Before Interest & Tax/ Total Assets: - An effective way of assessing a firm‘s ability to profit from its assets before things like interest and tax are deducted.
(iv) Market Value of Equity/ Total Liabilities: - A ratio that shows, if a firm were to become insolvent, how much the company‘s market value would decline before liabilities exceed assets.
(v) Sales/Total Assets: - A measure of how management handles competition and how efficiently the firm uses assets to generate sales.
Based on the Multiple Discriminant Analysis, the general model can be described in the following form:
Z=1.2WC/TA + 1.4 RE/TE + 3.3 EBIT/TA + 0.6 MVE/TL + 1.0 SL/TA
Probability of failure according to the Z-Score result:
Z-Score Probability of Failure
Less than 1.8 Very High
Greater that 1.81 but less than 2.99 Not Sure
Greater than 3.0 Unlikely
Calculation of the Z-Score for a fictitious company where the different values are given to calculate the Z-Score.
The Z-Score model is a quantitative model developed by Edward Altman in 1968, to predict bankruptcy or financial distress of a business. The Z-score is a multi variate formula that measures the financial health of a company and predicts the probability of bankruptcy within 2years. This model involves the use of a specified set of financial ratios and a statistical method known as a Multiple Discriminant Analysis. (MDA). The real world application of the Altman score successfully predicted 72% of bankruptcies two years prior to their failure.
The model of Altman is based on a linear analysis in which five measures are objectively weighted and summed to arrive at an overall score that then becomes the basis for classification of companies into one of the two a priori groupings that is bankrupt or non-bankrupt. These five indicators were then used to derive a Z-Score. These ratios can be obtained from corporations‘ financial statements.
The five Z-score constituent ratios are:
(i) Working Capital/Total Assets (WC/TA):- a firm with negative working capital is likely to experience problems meeting its short-term obligations.
(ii) Retained Earnings/Total Assets: - Companies with this ratio high probably have a history of profitability and the ability to stand up to a bad year of losses.
(iii) Earnings Before Interest & Tax/ Total Assets: - An effective way of assessing a firm‘s ability to profit from its assets before things like interest and tax are deducted.
(iv) Market Value of Equity/ Total Liabilities: - A ratio that shows, if a firm were to become insolvent, how much the company‘s market value would decline before liabilities exceed assets.
(v) Sales/Total Assets: - A measure of how management handles competition and how efficiently the firm uses assets to generate sales.
Based on the Multiple Discriminant Analysis, the general model can be described in the following form:
Z=1.2WC/TA + 1.4 RE/TE + 3.3 EBIT/TA + 0.6 MVE/TL + 1.0 SL/TA
Probability of failure according to the Z-Score result:
Z-Score Probability of Failure
Less than 1.8 Very High
Greater that 1.81 but less than 2.99 Not Sure
Greater than 3.0 Unlikely
Calculation of the Z-Score for a fictitious company where the different values are given to calculate the Z-Score.
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