A Comparison of Bankruptcy Models

INTERNATIONAL JOURNAL OF MARKETING,
FINANCIAL SERVICES & MANAGEMENT RESEARCH
Vol.1 No. 4, April 2012, ISSN 2277 3622
Online Available at indianresearchjournals.com
A COMPARISON OF BANKRUPTCY MODELS
*DR. RADHA GANESH KUMAR, **KISHORE KUMAR,
*Associate Professor, Department of Management Studies, Valliammai Engineering College, Kattankulathur
** Managemnet Trainee, Congruent solutions, Chennai
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ABSTRACT
Financial analysis can be applied in a wide variety of situations to give business managers
the information they need to make crucial decisions. In Texmo there is a need for a pragmatic tool to make
the prediction of financial distress with a single formula with implementation of information system. An
empirical comparison of Bankruptcy models is done to obtain it. This study analyses three of the venerable
models for assessing the distress of industrial corporations. These are the so-called Z-Score model, O-score
model and Zmijewski's model. Z-Scores, O-score and Zmijewski's model are used to predict the
profitability that a firm will go into bankruptcy within two years, forecast corporate defaults and an easy-
to-calculate control measure for the financial distress status of companies in academic studies.
Bankruptcy, models, distress, corporations, control measures.Keywords:
INTRODUCTION measure of the probability of bankruptcy with Traditional
Academics in the fields of accounting and finance have financial analysis. The most important conclusion that the
actively studied bankruptcy prediction since the work of results of this study point out is that it is possible to predict
Beaver (1966, 1968), Altman (1968), Ohlson (1980) and financial distress and bankruptcy more accurately using the
Zmijewski's (1984). With few exceptions, this literature has domestic data through the foundation of new models based
relied on accounting-based measures as the predictor on different combinations of financial ratios, when
variables. More recent studies have used proxies for the compared to the old and more prestigious model proposals.
probability of bankruptcy (PB) as an independent variable It is so interesting and amazing to have produced a new
rather than as the dependent variable. These latter studies model proposal with a slightly better prediction
frequently obtain their PB proxies from the existing performance using the binary logistic regression technique
bankruptcy prediction literature, and hence, have relied on against the existing model proposals of the past researchers.
accounting-based measures. Many of these studies have used Our findings show that none of the existing prediction
composite measures that statistically combine several models could achieve a satisfactory level of prediction
different accounting variables, with Altman's (1968), performance. The correct-classification percentages of the
Zmijewski's(1984) and an derived from Ohlson's (1980) existing models are all below 96 %. None could generate
Model being the most popular, the performance of these accuracy level. The best model among the existing financial
accounting-based composite measures in explaining the distress prediction models is Ohlson's O-Score Model.
cross-sectional variation in the actual probability of Surprisingly, Altman's Z-score Model has produced lower
bankruptcy. levels of accuracy.
REVIEW OF LITERATUREThese models utilises multiple corporate income and balance
Edward I. Altman, Ph.D., a financial economist andsheet values to measure the financial health of a company.
professor at New York University's Stern School of Business,These models are still being used by practitioners
developed the Z-Score in 1968 says that Z-Score forecaststhroughout the world. The aim of the study is to assess
the probability of a company entering bankruptcy within awhether three popular accounting-based measures, Altman's
12-month period. Altman's model predicted with 95%(1968) , Ohlson's (1980) and Zmijewski's model (1992)
accuracy which sample companies filed bankruptcy withineffectively summarize publicly-available information about
12 months. In later studies, using broader samples ofthe probability of bankruptcy. The study compares the
companies analyzed during a variety of economic climates,relative information content of these to a market-based

the Z-Score accuracy rate remained in the 82% to 85% the traditional valuation model based on discounted future
range. dividends. Ohlson's O-score model is often referred to as the
residual income model since it expresses firm value as a
The model itself is not complicated. It combines five function of the book value of net assets and the present value
financial ratios using reported accounting information and of expected residual earnings on those net assets. Gary Klein
equity values to produce an objective measure of a firm's men express the application of the Zmijewski's model is
financial health. Altman's Z-Score remains popular after slightly more complex due to the methodology used to
almost 30 years because it is easy to calculate. Other generate the parameters. Zmijewski's model is also known as
bankruptcy prediction models exist, some of which are more probit analysis, which is why two steps are required beyond
accurate, especially over a horizon greater than two years. those applied for discriminant analysis-based models such as
However, they are more complex and most are proprietary. the previously presented Altman Model. First, the constant
Bum J Kim says that while the model was developed to and each parameter of the model must be multiplied by
analyse manufacturing companies, it can also be applied to 1.8138 and then multiplied by the financial measure. Two
non-manufacturing organizations by modifying the alternative sets of parameters are provided, either of which
formula. To do so, the first four components of the formula can be used for estimation weighted measures are based on
(Xl to X4) are used and the fifth component (x5) is omitted. varying proportions of bankrupt and non bankrupt firms.
The adjusted formula seems to provide equally valid
OBJECTIVES OF THE STUDYpredictive result. Altman, Haldeman and Narayanan (1977)
• To perform a comparison of Bankruptcy models withconstructed a second generation model with several
traditional analysis in "Texmo Industries, Coimbatore"enhancements to the original Z-Score approach. The
• To find out the probability of Bankruptcy throughpurpose of this study was to construct, analyze and test a
Altman Z-score, Ohlson's O-score, and Zmijewski'snew bankruptcy classification model which considers
model at Texmo Industries for the years 2005-2006explicitly recent developments with respect to business
to2009-2010.failures. The new study also incorporated refinements in the
• To compare the Z-score, O-score, and Zmijewski'sutilization of discriminant statistical techniques. Several
score with traditional financial parameters. To find outreasons for building a new model, despite the availability of
the model that is the best predictor of bankruptcy. Toseveral fairly impressive "old" models, are presented below
forecast the probability of bankruptcy for 2010-2011 toand the empirical results seem to substantiate the effort. The
2013-2014.To estimate correlation between net profitnew model, which we call ZETA, was effective in classifying
and probability of bankruptcy prediction model.bankrupt companies up to five years prior to failure on a
• To give suggestions to improve the financialsample of corporations consisting of manufacturers and
performance of Texmo Industries.retailers. Since the ZETA model is a proprietary effort, I
cannot fully disclose the parameters of the market.
SCOPE OF THE STUDYKin Lo and Thomas Lys", says, review of the Ohlson's
The study is conducted at Texmo Industries. The duration ofModel suggests that it extends the literature on valuation.
the study was confined to about four months .This study isThe revival of residual income valuation is notable on its
based on the collected data for five years i.e., 2005-2006 toown. Added to that, the parsimonious information
2009-2010.The major scope of the study are:dynamics translates expectations of the future to current
• To provide information about the financial position,observables. While the model's core has been known for
performance and changes in financial position of Texmomany decades, the OM is built upon the more solid
Industries that is useful to a wide range of users infoundation of Modigliani and Miller. Finally, the model is
making economic decision.elegant and lends itself to extensions that analyze accounting
• The study will help the company to understand whatissues such as conservatism and growth, as demonstrated by
sort of changes they should make in future.Feltham and Ohlson (1995).
• All the factors are studied based on the past data leavingOhlson (1995) and Feltham and Ohlson (1995)
scope for further research in the field which coulddemonstrate that equation is mathematically equivalent to
DR. RADHA GANESH KUMAR, KISHORE KUMAR
77

further change according to dynamic environment. 1.1<Z<2.59: Grey Zone
Z<1.1: Unhealthy Zone
RESEARCH METHODOLOGY
Table No 1: Altman's Z-Score AnalysisAnalytical research is adopted for this study. Analytical
Research is primarily concerned with testing hypothesis, Year X1 X2 X3 X4 Altman Zones of
specifying and interpreting relationships, by analyzing the Z-Score Discrimination
facts or information already available. 2005-06 0.8036 0.0739 0.14 1.82 8.36433 Healthy
Zone
2006-07 0.8222 0.0506 0.111 1.59 7.974008 HealthyDATA COLLECTION
ZoneThis study on bankruptcy models, ratio analysis, changes in 2007-08 0.8788 0.2215 0.3546 0.69 9.59443 Healthy
working capital was purely based on secondary data. All the Zone
details necessary for conducting this study was available 2008-09 0.7119 0.1229 0.2198 0.42 6.988774 Healthy
within the company itself in the form of records. Zone
However, primary data also collected through 2009-10 0.7008 0.0415 0.0984 0.15 5.551286 Healthy
Zoneinteraction with the concerned executives in the finance
department of the organization. INTERPRETATION
On analysing the Z-score for the years, the profit
TOOLS USED FOR THE STUDY component X3 has increased during the first three years it is
The tools used for the study are listed as follows. in the decreasing trend in the recent past. The retained
1. Z-score Analysis earnings component X2 is meager for the analysis period
2. Ohlson's O-score Analysis and it has reached a value of 22. The equity component X4
3. Zmijewski's Analysis shows that there was a good return in the year 2005-06.The
equity component X4 has reduced over the years. The
DATA ANALYSIS AND INTERPRETATION liquidity component shows a moderate trend. The company
has to maintain the healthy zone by increasing profit
Z-SCORE ANALYSIS component as well as the equity component.
The Z-score is a linear combination of four or five common
business ratios, weighted by coefficients. The coefficients Graph No:1 Graph Showing Z Scores in the past years
were estimated by identifying a set of firms which had 2005-06 to 2009-09
declared bankruptcy and then collecting a matched sample
of firms which had survived, with matching by industry and
approximate size (assets).
Altman applied the statistical method of discriminant
analysis to a dataset of publicly held manufacturers. The
estimation was originally based on data from publicly held
manufacturers, but has since been re-estimated based on
other datasets for private manufacturing, non-
manufacturing and service companies.The Z-Score model
for Private industrial companies is:
Z=6.56 X1+ 3.26 X2 + 6.72 X3 + 1.05 X4.
X1=Working Capital/Total Assets
X2= Retained Earnings/Total Assets
X3=Earnings before Taxes + Interest/Total Assets
X4=Market value of Equity/ Total Liabilities
Z>2.60: Healthy Zone
A COMPARISON OF BANKRUPTCY MODELS
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INTERPRETATION TA - Total Assets,
The probability of Bankruptcy from Altman Z-score should TL - Total Liabilities,
CA - Current Assets,
be less than 0.5 for Non-failed Company. Probability is less CL - Current Liabilities,
than the value 0.5; hence the firm is in the Non-Bankruptcy NI - Net Income,
EBITDA - Earnings Before Interest and Taxes,range. Over the years 2005-2006, 2006-2007 probability
has been reduced. It shows a probability of 0.4177 in the INTWO - Indicator equal to 1 if net income was negative for
year 2007-2008 that the recession plays a major part to the last two years or 0, if otherwise,
OENEG - Indicator equal to 1 if book value of equity isincrease the Bankruptcy rate in the firm, but it was well
negative or 0, if otherwise.managed in the consecutive years and the financial distress
The O - score obtained by the model doesn't represent
was reduced.
bankruptcy probability but can be transformed into a
OHLSON'S O-SCORE probability using the logistic transformation:
Ohlson selected nine independent variables that he thought
should be helpful in predicting bankruptcy, but provided no
theoretical justification for the selection.
The final score indicating the probability of default is
between 0 and 1.
P(O-Score) > 0,50 => FailedWhere, size is inflation adjusted total assets,
Otherwise => Non-FailedWC - Working Capital,
Table No 2: Probability Of Bankruptcy By Z-Score -Standardised Normal Distribution Value
DR. RADHA GANESH KUMAR, KISHORE KUMAR
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