Engineering Management In terna tional, 3 ( 1985) 165-l 74 165

Elsevier Science Publishers B.V., Amsterdam - Printed in l%e Netherlands

NAWZIN E FOR MANAGERI

EMENTAN BANKRU
PREDICTION
Arshad M. Khan

Department of Industrial Engineering, University of Texas, Arlington, TX 76019 (U.S.A.)

ABSTRACT

Financial statements contain significant
information on the financial well-being of a
company. In this paper, the author considers
techniques for statement analysis and dis-
cusses the interpretation of results. Many of
the variables arising from such analysis can be
used to develop statistical models that are
quite successful as early-warning indicators of
corporate bankruptcy. The author examines
some of these bankruptcy prediction models
and discusses their performance.

INTRODUCTION was also higher than at any time since the

early 193 0s.
In a previous article (Khan, 1985) I dis- The scope of this paper is limited to finan-
cussed the basic financial accounting structure cial statement analysis and to a review of
and the major financial statements together some of the major bankruptcy prediction
with the theory underlying them. I also ex- models. The analysis is conducted on the
amined inherent assumptions and consequent statements of Timujin Corporation intro-
limitations. The enormous amount of in- duced in the prior article (Khan, 1985) and
formation contained in these statements can reproduced here as Exhibits 1, 2, and 3.
be analyzed further. Termed financial state
ment analysis, this serves to assess financial
soundness, performance and efficiency. FINANCIAL STATEMENT ANALYSIS
A more specialized area of interest is bank-
ruptcy prediction. Researchers have devel- The basic accounting equation represented
oped mathematical models from financial by the balance sheet is
statement variables that have had reasonable
Resources = Claims on Resources.
predictive success; and recent economic
history has given this work added importance. The resources of a firm are called assets. And
Business Week (May 17, 1982, p. 110) re- rights or claims to these assets are called
ported a business _ailure rate in 1982 that was equities (Kern and Boyd, 1983). So the
50 percent higher than the previous year - it accounting equation can be rewritten as
Assets = Equities

0167-5419/85/$03.30 o 1985 Elsevier Science Publishers B.V.

166

EXHIBIT 1
Timu jin Corporation
Comparative Statement of Financial Position
December 31,198l and 1982
ASSETS December 31

Current Assets: 1981 1982

Cash $ 80,000 $ 130,000
Accounts Receivable from Customers 85,000 210,000
Merchandise Inventory 125,000 200,000

Total Current Assets $ 290,000 $ 540,coo

Noncurrent Assets (at acquisition cost):

Land $ 50,000 $ 50,000
Equipment (net of accumulated depreciation)* 7 50,000 950,000
Buildings (net of accumulated depreciation)* 850,000 800,000

Total Noncurrent Assets $1,650,000 $1,800,000

Total Assets $1,940,000 $2,340,000

LIABILITIES AND SHAREHOLDERS’ EQUITY

Current Liabilities:
Accounts Payable to Suppliers $ 130,000 $ 165,000
Salaries Payable to Employees 30,000 45,000
Income Taxes Payable to Federal Government 50,000 100,000
Total Current Liabilities $ 210,000 $ 310,000

Noncurrent Liabilities:
Bonds Payable to Lenders (due 1998) 700,000 800,000
Total Liabilities $ 910.000 $1,110,000

Shareholders’ Equity:
Common Stock ($10 par) $ 400,000 $ 440,000
Capital Paid in Excess of Par 100,000 110,000
Retained Earnings 530.000 680.000
Total Shareholders’ Equity $1,030,000 $1.230.000
Total Liabilities and Shareholders’ Equity $1,940,000 $2,340,000

*Net figures are used for simplicity. Accounting reports would separate out gross
acquisition cost and accumulated depreciation.

There are two kinds of claims on a firm’s within one year and noncurrent otherwise. A
resources: those of creditors, called liabilities; similar classification is made for assets.
and those of the owners, termed shareholders’ Users of financial statements are interested
equity. Subdividing the equities in this man- in evaluating company performance - often
ner, the equation becomes described as profitability consistent with
Assets = Liabilities + Shareholders’ Equity. financial soundness (Anthony and Reece,
1979; Riggs, 1981). Measures of profitability
Liabilities consist of payables (obligations for enable performance comparison with industry
services or goods received) plus debt. They are norms. Further measures assess financial
generally considered current liabilities if due soundness, by examining liquidity - the avail-
 167

EXHIBIT 2
Timujin Corporation
Statement of Net Income
for the Year Ending December 31,1982
Revenues:
Sale of Merchandise $2,2OO,OOO
Sale of Engineering Services 250,000
Interest on Customers’ Uncollected Accounts 15,000
Total Revenues $2,465,000

Less Expenses:
Cost of Merchandise Sold $ 800,000
Salaries Expense 450,000
Depreciar;ion Expense 250,000
Selling and Administr&tive Expenses 400,000
Interest Expense 50,000
Income Tex Expense 140,000
Total Expenses _$2,090,000

Net Income $ 375,000

ability of resources easily converted to cash, The ratio numerator, net income, is derived
capital structure - the relative proportions of from the use of all capital sources, namely,
debt and shareholders’ equity, and lastly, the ?:abilities plus shareholders’ equity. But the
firm’s ability to discharge long-term obliga- ratio denominator consists only of average
tions. Since many of these measures are ratios shareholders’ equity. Consequently, for two
of statement items, this kind of analysis is firms that are comparable in all respects but
also referred to as ratio analysis. capital structure, the one with the larger debt
(therefore larger liabilities and smaller share-
holders’ equity) will generally show a higher
Performance ROE, particularly when the interest rate on
debt is lower than the return the company
Of primary interest to a stockholder is the obtains from the debt capital. However, a
return he realizes for providing capital. And it highly leveraged firm, that is, one with a high
is measured by &turn on Shareholders’ level of &bt to shareholders’ equity, bears
Equity ROE). In general, a higher ROE is greater risk. Such a firm is likely to show
preferred. greater fluctuation in net earnings between
good and bad times, because it has a larger
Net Income
ROE = fixed interest obiigation. Suppose a firm pays
Average Shareholders’ Equity $10 million in interest, and its earnings before
where the denominator average used here, interest increase from $12 million to $16 mil-
and in some subsequent ratios, is calculated lion. Then net earnings after interest will rise
by adding the beginning and ending balance from $2 million to $6 million, a 300 percent
sheet amounts and dividing by two. For increase. The same firm without debt would
Timujin Corporation: show an increase from $12 million to $16 mil-
lion or merely 33.3 percent.
375,000 As we have seen, the ROE fi~tirz is sensitive
= 33.18%
R*E = ?4(1,030,000 + 1,230,OOO) to capital structure. If we wish to omit the
 EXHIBIT 3
Timu jin Corporation
Statement of Changes in Financial Position
for the Year Ending December 31, 1982
Sources of Cash
Operations:
Net Income $3 74,COO
Additions:
Depreciation Expense 250,006
Increases in current liabilities:
Accounts Payable 3 5,000
Salaries Payable 15,000
Income Taxes Payable 50,000
Subtractions:
Increase in Accounts Receivable (125,000)
Increase in Inventory (75,000)
Cash provided by operations $525,000

Other Sources:
Proceeds from Issue of Long-Term Bonds 100,000
Proceeds from Issue of Common Stock 50,000
Total Sources of Cash $675,000

Uses of Cash :
Dividends 225,000
Acquisition of Buildings and Equipment 400,000
Total Uses of Cash (625,000)
Net Increase (Decrease) in Cash for 1982 $ 50,000
Net Increase (Decrease) in Cash Account
$ 50,000
for 1982 - from Balance Sheet

influence of capital structure and measure just purer measure of efficiency. It demonstrates
the efficiency with which an enterprise has how well a company has used its total assets.
used its funds, then Return on Assets (ROA) Appropriately, it is often used by top manage-
is a useful ratio. ment to evaluate divisions and their managers,
because it excludes the effect of financing
Earnings Before Interest and Taxes decisions for which division managers are not
ROA =
Average Total Assets responsible, while measuring the efficiency
with which assets are utilized, for which the
Timujin Corporation’s ROA = managers are responsible.
375,000 + 140,000 + 50,000 There is a secondary ratio called Return on
= 26.40% Invested Capital. In it, current liabilities are
‘/2(1,940,000 + 2,340,OOO)
subtracted from the ROA denominator leav-
Total assets equal liabilities (payables and ing long-term debt plus stockholders’ equity.
debt) plus shareholders’ equity. Hence to This remainder is called permanent capital.
match the numerator to the denominator and When division managers have a significant
to keep t’rle ratio independent of capital influence on credit policy and cash manage-
structure, the earnings numerator must in- ment policy, namely, on working capital
clude interest payments on debt. And when management, this ratio is often preferred over
tax payments are excluded, it becomes a ROA for measuring division performance.
 169

Earnings Per Share (EPS) is commonly Timujin Corp.% Debt Equity Ratio =
quoted as an overall performance measure. 800,030
-- = 0.65
1,230,ooo
Earnings per share =
Net income Another measure that examines a com-
Average number of common shares pany’s ability to service its debt is Times
Interest Earned. It indicates a company’s
375,000 margin of safety, and a higher ratio implies a
= 8.93
= %(40,000 + 44,000) better ability to survive recessionary periods
without going into default. In recent memory,
For complex capital structures, with pre- both Chrysler Corporation and international
ferred stock, convertible debt, options, war- Harvester have had difficulty with creditor
rants, etc., the calculation of EPS can become demands: to stave off bankruptcy, the former
quite involved because of the potential that was granted government guarantees on its
exists for dilution through the conversion into loans, the latter received a debt restructuring.
common stock of options and convertibles.
Times Interest Earned =
Given a public company, we can divide the
quoted market price per share by EPS to Earnings Before Interest and Taxes
obtain the Price Earnings Ratio (P/E Ratio). Interest Expense
It serves as a measure of how expensive or
inexpensive a company’s stock is, in com- 375,000 + 140,000 + 50,000
= = 11.30
parison with other related stocks. 50,000

Long-Term Solvency Liquidity (Short-term solvency)

Profitability ratios primarily assess per- There is an inevitable unevenness in the

formance. In contrast, solvency (the ability to flow of funds into and out of a company
pay debts when due) and liqu.idity (the level because collections from customers rarely
of cash convertible resources) ratios test coincide with payments to employees, sup-
financial condition. Dividends are paid to pliers, or other creditors. A company must
shareholders by vote of the board of di- therefore maintain sufficient liquidity as a
rectors. They are based on the number of safety buffer to be certain of paying its bills
shares held and can be discretionary. when they come due. The Current Ratio is
However, a company must meet principal and probably the most widely used measure of
interest obligations to holders of debt or it liquidity.
will run the risk of bankruptcy. One way of
C-urrent Assets
assessing this risk is to measure the Ratio of Current Ratio =
Debt to Shareholders’ Equity? Current Liabilities
Long-Term Debt For Timujin Corp. the Current Ratio =
Debt Equity Ratio =
Total Shareholders’ Equity 540,000
= 1.74
310,000
If only cash equivalents are included in the
numerator, which then excludes inventory,
*Readers need to be cautioned that definitions of the resulting ratio is called a Quick or Acid-
Debt Equity Ratio vary. Sometimes all liabilities are Test Ratio. The exclusion of inventory is
included in the numerator, and the denominator can based on the premise that financial distress in
comprise all liabilities plus equity.
a recessionary period may be accompanied by 365 365
=- = 21.84
lackluster sales, and therefore the inventory Accts. Rec. Turnover 16.71
xay not be readily convertible into funds.
For such ratios, the numerator depends on
Quick Ratio = the reporting period and it is 365 when this
Cash + Marketable Securities + Receivables period is one year. A high collection period in
comparison with similar firms indicates the
Current Liabilities
firm is allowing free credit to its customers
for longer than necessary.
I_ 340,000 = l lo
In a similar manner, the efficiency of
310,000 l

inventory utilization is determined by

The higher the current or quick ratio, the Inventory Turnover and Days Inventory.
greater the liquidity and margin of safety However, since inventory is norAmally valued
enjoyed by the firm. In assessing liquidity on the balance sheet at cost, the numerator in
with these ratios, it is of course important to the inventory turnover ratio is cost of sales
relate them to the nature of the firm. Thus a (cost of goods sold) as opposed to sales re-
service firm may have no inventory, or a venues. Again, a higher turnover is desirable.
retailer with little or no receivables may have
Cost of Sales
an inherently low quick ratio. Inventory Turnover =
Average Inventory
800,000
Capital Utilization = = 4.92
1/2(125,000 + 200,000)
There are a series of ratios that measure 365
the efficiency of capital utilization. They test Days Inventory =
Inventory ‘Turnover
working capital (current assets minus current 365
liabilities) and nonworking capital items = - = 74.19
against sales revenues generated. Thus 4.92
Accounts Receivable Turnover is an indicator Fixed Asset Turnover measures how well
of the level of investment in accounts plant and equipment are being utilized to
receivable. generate sales.

Accounts Receivable Turnover = Sales

Fixed Asset Turns-tier =
Credit Sales Average Fixed Assets
Average Accounts Receivable 2,465,OOO
= 1.43
Assuming all sales are on credit, then for = %(1,650,000 + l,SOO,OOO)
Timujin Corp.,
This ratio also indicates capital i&entity.
Accounts Receivable Turnover = Certain types of companies are capital inten-
2,465,OOO sive, that is, their businesses require heavy
= 16.71 investment in plant and equipment. s,uch
%(85,000 + 210,000) companies are particularly sensitive to e?3on-
An ancillary ratio is Accounts Receivable omit downturns and are called “cyclicals”.
Collection Period .:;hich gives the average Examples would be automobile manufac-
number of days it takes the firm to collect on turers or steel companies.
. Overall asset utilization is given by Total
credit sales.
Asset Turnover.
Accounts Receivable Collection Period =
 171

sales Earnings Before Interest and Taxes (EBIT)

Total Asset Turnover =
Average Total Assets Total Assets
2465,000 EBIT Total Sales
= 1.15 =
= %(1,940,000 + 2,340,OOO) Total Sdes 1 l ( Total Assets
Operating Margin Total Asset Turnover
Operational Efficiency Separating the margin and turnover ratios
allows us to focus independently on costs of
Another series of ratios focusses on the operations and asset utilization.
costs of operations. The Operating Margin
Ratio Serves as an indicator of overall opera- Return on Equity =
tional efficiency.
Net Income
0per:ating Margin Ratio = Total Shareholders’ Equity
Earnings Before Interest and Taxes (EBIT) EBIT - Interest - Taxes
Sales Total Shareholders’ Equity
= 1- c Margin Ratios EBIT - Interest - Taxes

Margin ratios are various expense items Total Assets

represented as a fraction of sales. To dcter- Total Assets \
mine how efficiently a firm controls its costs, Total Shareholders’ Equity 1
these ratios can be calculated and compared
with those of other firms in the same busi-
ness. For Timujin Corporation (Exhibit 2), Taxes \
the relevant margin ratios are Cost of Mer-
chandise f Sales, Salaries Expense f Sales,
Depreciation + Sales, and Selling and Admini- Taxes
strative Expenses + Sales. Computed directly ,
Rzz on EGe
the overall
Assets Tax Rate
EBIT
Operating Margiiri Ratio = - = Total Assets
Sales
Total Shareholders’
375,000 * 50,000 + 140,000 Equity )
= 0.23 (_/
2,465,OOO Leverage Proxy
The ratio Total Assets divided by Total
Shareholders’ Equity serves as a proxy for
Linkage
debt leverage: when debt is relatively high the
denominator is proportionately small, which
It is useful to realize the interconnection
makes the ratio large.
between ratios for it clarifies occasional
In a two-company comparison, one com-
inconsistencies in comparisons between com-
pany could have a higher return on assets, the
panies (Khan, 1983). Thus
other a higher return on shareholders’ equity.
Return on Assets = As the linkage shows, the explanation for the
apparent inconsistency would probably lie in
debt leverage.
172

BANKRUPTCY PREDICTION MODELS bines five financial variables, with statistically

derived weights, to arrive at an overall score.
The costs of bankruptcy are severe, both in Termed the Z-Score it can be computed from
economic terms for the stockholders, and in a modified version of the model given by the
social terms for the employees, their families, empirically derived equation
and in many instances, the community at z= 1.2x1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
large. A unique and effective use of financial
ra:ios is in their use as early-warning in- where X1 = Working Capital/Total Assets
dicators of impending danger. The models X2 = Retained Earnings/Total Assets
discussed here utilize financial statement X3 = Earnings Before Interest and
variables and are based on studies of in- Taxes/Total Assets
dustrial firms. Zavgren (1983) has presented a X4 = Market Value of Equity/Book
comprehensive review of several such models. Value of Total Liabilities, and
Beaver (1967), one of the early researchers xs = Sales/Total Assets
in this area, examined the predictive ability of The accuracy of Altman’s model was
finan&u ratios taken individually. He com- greater than Beaver’s univariate model only
pared the mean values of each of his ratios for for the first year before bankruptcy, dropping
failed and nonfailed firms. Cash flow to total off sharply thereafter, while Beaver was able
debt was the best performing ratio, and it had to make accurate predictions five years before
an error rate of 13 percent for the year prior failure.
to failure. This means that 13 percent of A second model, dubbed Zeta, developed
sample firms were misclassified by the model. by Altman, Haldeman and Narayanan [ 2] has
As the testing sample consisted of an equal improved on the performance of the Z-Score
number of failed and nonfailed iirms, a naive model. The coefficients of the Zeta model
prediction would have had an error rate of have been kept proprietary and one cannot
50 percent. Beaver’s error rate increased with derive Zeta scores without subscribing to the
time, and it was 22 percent five years prior to Zeta service.
failure. But even this was a significant im- The approach taken in the Zeta model is
provement over the naive model. Other pre- similar to Meyer and Pifer’s earlier work
dictors, identified in declining order of suc- (197 0) which utilized financial data from
cess, were total debt over total assets, working more than one period to determine the time
capital over total assets, and current assets trend. However, a comparison by Collins
over current liabilities. The importance of (1980), of the Meyer and Pifer model with
cash flow demonstrated by Beaver became Altman’s original Z-Score model, showed that
prevailing doctrine and led to the increased performance did not justify the additional
importance of such a funds statement. sophistication of the Meyer and Pifer model.
The main difficulty with Beaver’s approach On further statistical examination of the
is the use of only one ratio at a time. It leave3 financial ratios he employed, Beaver (1967)
open the possibility of conflicting results noted evidence of characteristics that, to him,
from different ratios. In addition, the finan- made multivariate analysis highly suspect.
cial profile of a firm is multidimensional and Deakin (1976) found the distributions of
therefore cannot be reflected in a single ratio. financial ratios to be nonnormal and
The natural extension of Beaver’s univariate Diamond’s tests (1976) indicated that such
model then is a multivariate model. ratios were normal only if outliers were
Altman’s ( 196 8) model employed multiple omitted. Statistical significance tests on the
discriminant analysis, a statistical technique ability of the discriminant function to dis-
that enables the multidimensional character- tinguish between dichotomous populations
istics of a population to be transformzd into a (failed and unfailed firms) require the assump-
single dimensional measure. His model com- tions of normality and equal variances. And
 173

there is some evidence (Eisenbeis, 1977) that Again, ratios serve as indicators. It is then
nonnormality can affect predictive accuracy up to the analyst to examine the unexpected
of the discriminant function. further. For example, a reduction in in-
Another concern is multicollinearity. In a ventory turnover, normally undesirable, could
strict sense such intercorrelations among well reflect a conscious management decision
predictor variables are not a problem in dis- to accumulate a scarce commodity.
criminant analysis. However if present, they Accounting statements are historical and
require the assumption that such intercor- therefore these ratios represent the past.
relations are stable, that is, they are the same Investment decisions however require an
in the sample group and the group to be assessment of the future so that when ratio
tested. analysis is used, a process of extrapolation is
Diamond (1976) attempted to avoid these implied. More commonly, ratio analysis serves
statistical shortcomings by rigorous testing of as an important starting point for further
data. He also tried several forms of the dis- evaluation and comparison.
criminant function in an effort to optimize In the prediction of business failure, finan-
predictive ability. He used a linear discrim- cial ratios, when incorporated in statistical
inant function, a quadratic discriminant models, have been increasingly successful.
function, and also a Bayesian probability Many such models perform with success rates
classifier that included the prior probabilities in excess of 90 percent one year prior to
of failure in the population. His overall result, failure and a few approach 80 percent as
however, did not show much improvement much as five years before bankruptcy.
over previous studies signalling a leveling off
in the predictability characteristics of this
type of model, REFERENCES
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(1984), which was also mentioned in the Wall Altman, E., 1968. Financial ratios, discriminant
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174

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