FORECASTING FINANCIAL FAILURE There have been many academic studies on the use of financial ratios to forecast financial failure. Basical'y, these studies try to isolate individual “ratios or combinations of ratios that can be observed as trends that may ~ forecast failure. ; Areliable model that can be used to forecast financial failure can also be used by management to take preventive measures. Such a model can aid investors in selecting and disposing of stoc::.. Banks can use it to aid in lending decisions and in monitoring loans. Firms can use it in making credit decisions and in monitoring accounts receivable. In general, many sources can use such a model to improve the allocation’ and control of resources. A model that forecasts financial failure can also be valuable to an auditor. It can aid in the determination of audit procedures and in making a decision as to whether the firm will remain as a going concern. Bon acral pgiicre can be described in many ways. It can mean liquide Fe interest onition Paras to erent credi tors, deferment of pa ae omission of a pre fonred aise 7 Payments of Principal on bonds, or literature on forecastin; finan i nes ee the problems in eran ee ee different criteria to nea rn pe cial failure is. that different ae Ea ‘determine the criteria used to ee When reviewing the titerature, alw4) : . lefine financial failure. Scanned with CamScannerThis book reviews two ke 8 of the 5 es failure, Based on the number of rf teat erature, they appear to be Particulart i ing financial failure. wy ‘al with predi cling NCeS to these two studio BNHLCANE ON the subject of financial inv the hit forecast Univariate Model William Beaver reported his Univariate mod The Accounting Review in October Lea? ee variable. Such a model would use indi raiab se individual financial ratios to fore financial failure, The Beaver study classified frm ms tlle one et of the following events occurred in the 1954-1964 period: bankruptcy, bord default, an overdrawn bank account, or Nonpayment of a preferred stock dividend, Beaver paired 79 failed firms with a similar number of successful firms drawn from Moody's Industrial Manuals. For each failed firm in the sample, a successful one was selected from the same industry, The Beaver study indicated that the following ratios were the best for forecasting financial failure (in the order of their predictive power): rin a study published in A univariate model uses a single ses 1. Cash flow/total debt 2. Net income/total assets (return on assets) 3. Total debt/total assets (debt ratio) Beaver speculated as to the reason for these results: i ation of the finding is that the cash flow, net income, hy nro he i pn pean ‘ cls of the firm. Because failure is too costly to all involved, De p ent, rather than the short-term, factors largely deter- ie eraiher or not a firm will declare bankruptcy or default on . s oe ified by Beaver are valid in forecasting aa e ing that the ate ee fo pay particular attention to trends in Dre n following a firm. Beaver’s reasoning for seeing these pe recasting financial failure appears to be very sound. tios for Cooper for 1995 have been computed earlier. Cash 35.69%, which appears to be good. Net income/' total ts) was 10.33%, which appears to be good. The debt is very good. Thus, Cooper appears to have minimal 0 computed the mean values of 13 financial state- before failure. Several important relationships liquid asset items.’ Scanned with CamScannerSev CHART EXPANDED UTELLY OF Pivaneta Vaile firme have tess cagh but more accor (8 tecvivable and receivables are added together as they aga in san Current Agneta, the difference between faite wel RueC ess TUT ine i obscured because the ea Nand receivab sidetences are working in opposite directions When ea wk a } Faited tims tend to have lex taventory, these results indicate that particular attention should be p SURAT Assets When fore and iwentory, The anal high accounts receivable, »aid to three ing financial failure: cash, accounts receivable, should be alert for low cash and inventory and Multivariate Model Fdward 1 Altman developed ruptey:® His model uses five the predicti nant score, a multivariate model to predict bank. financial ratios weighted in order to maximize * power of the model. The model produces an overall discrimi- alled a Z score. The Altman model is as follows; Z = OI2N, + O14 X, + 033 X, + 006°, + .010 x, X, = Working Capital/Total Assets This computation isa measure of the net liquid assets of the firm relative to the total capitalization, X, = Retained Earnings (balance sheet)/Total Assets This varifdle measures cumulative profitability over time X, = Earnings Before Interest and Taxes/Total Assets This variable measures the productivity of the firm’s assets, abstracting any tax or leverage factors. X, = Market Value of Equity/Book Value of Total Debt This variable measures how much the firm's assets can decline in value before the liabilities exceed the assets and the firm becomes insolvent. Equity is measured by the combined market value of all shares of stock, preferred and common, while debt includes both current and long-term debts. X, = Sales/Total Assets This variable measures the sales-generating ability of the firm’s assets. coniputing the Z score, the rahos are expressed in absolute renee age terms Thus, X, (working capital /total assets) of 25% is noted as 25. Scanned with CamScannerCHAPTER 13. EXPANDED UTILITY OF FINANCIAL RATIOS 567 The Altman model was developed using manufacturing companies whose asset size was between $1 million and $25 million. The original sample by Altman and the test samples used the period 1946-1965. The model's accuracy in predicting bankruptcies in more recent years (1970- 1973) was zeported in a 1974 article." Not all of the companies included in the test were manufacturing companies, although the model was initially developed by using only manufacturing companies. With the Altman model, the lower the Z score, the more likely that the firm will go bankrupt. By computing the Z score for a firm over several years, it can be determined if the firm is moving toward a more likely or less likely position in regard to bankruptcy. In the more recent study that covered the period 1970-1973, a Z score of 2.675 was established as a practical cutoff point. Firms that scored below 2.675 are assumed to have chavacteristics similar to those of past failures.” Current GAAP récognizes more liabilities than the GAAP used at the time of this study. Thus, we would expect firms to score somewhat less than in the time period 1970- 1973. The Altman model is substantially less significant if there is no firm market value for the stock (preferred and common), because variable X, in the model requires thac the market value of the stock be determined The Z score for Cooper at the end of 1995 follows: Z = .012 (working capital/total assets) + .014 (retained earnings [balance sheet]/total assets) + .033 (earnings before interest and taxes/total assets) + .006 (market value of equity/bavk ‘value of total debt) + .010 (sales/total assets) Z_ = .012 ([$430,584,000 - $158,368,000]/$1,143,701,000) .014 ($672,373,000/$1,143,701,000) .033 ({$180,070,000 + $697,000]/$1,143,701,000) 006 ({83,661,972 x $24.63]/[$158,368,000 + $28,574,000 + $132,963,000 + $38,341,000 + $36,656,000]) 4.010 ($1,493,622,000/$1,143,701,000) 012 (23.80) .014 (58.79) .033 (15.81) .006 (521.80) .010 (130.60) 29 + 82 + 52 + 3.13 + 1,33 te +n tee ege Zz Z = 6.07 The Z score tor Cooper at the end of 1995 was 6.07. Considering tha? higher scores are better and that companies with scores below 2.675 are assumed to have characteristics similar to those of past failures, Cooper is a very healthy compary Scanned with CamScannerPTER 13, EXPANDED UTILITY OF FINANCIAL RATIOS ; 595 $12 The following data are for the A, B, and C Companies. Company Variables . A B c Current assets : $150,000 $170,000 $180,000 Current liabilities $ 60,000 $ 50,000° $ 39,000 Total assets $300,000 $280,000 $250,000 Retained earnings $ 0,000 $ 90,000 $ 60.0.0 Earnings before interest and taxes $ 70,000 $ 60,000 $ 50,000 Market price per share $ 20.00 $ 1875 $ 1650 Number of shares outstanding 9.000 9,000 9,000 Book value of total debt $ 30,000 § 50,000 $ 80,000 Sales $430,000 $400,000 $ 200,000 quired a. Compute the Z score for each company. . b. According to the Altman model, which of these firms is most likely to experience financial failure? > Scanned with CamScanner