this file presents Altman Z score and the descriptive model of A score as a means of bankruptcy prediction and management to prevention.

1. BANKRUPTCY
PREDICTION AND
PREVENTION
Altman Z Score

2. Z SCORE BANKRUPTCY MODEL
• The Z-score formula for predicting bankruptcy was published in 1968 by Edward I.
Altman, who was, at the time, an Assistant Professor of Finance at New York
University.
• The Z-Score Test lets you use statistical techniques to predict the likelihood of
bankruptcy within the next two years.
• Dr. Altman's test was developed using 66 companies, The test achieved an accuracy
rate of 95%.
• The financial ratios come directly from a company's financial statements.

3. Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + .999X5
• T1 = Working Capital / Total Assets
• T2 = Retained Earnings / Total Assets
• T3 = Earnings Before Interest and Taxes / Total Assets
• T4 = Market Value of Equity / Total Liabilities
• T5 = Sales/ Total Assets

4. ZONES OF DISCRIMINATION:
ORIGINAL Z - SCORE MODEL (1968)
4
Z > 2.99 - “Safe” Zone
1.8 < Z < 2.99 - “Grey” Zone
Z < 1.80 - “Distress” Zone

5. RATIO A, WORKING CAPITAL / TOTAL
ASSETS
• is a liquidity measure. Working capital is comprised of cash and any other assets
that can be turned into cash on fairly short notice. The more working capital a firm
has, the more cushion it has to meet any bills coming due.

6. RATIO B, RETAINED EARNINGS / TOTAL
ASSETS
• is a measure of leverage. It tells us whether the firm is paying for assets using
profits or using debt. A high ratio indicates that profits are being used to fund
growth, while a low ratio indicates that growth is being financed through increasing
debt levels.

7. RATIO C, EBIT / TOTAL ASSETS
• is a profitability measure also known as return on assets (ROA). It measures the
amount of operating income generated by each dollar of assets.

8. RATIO D, MARKET CAP / TOTAL
LIABILITIES
• is a measure of the market’s confidence in the company as reflected in its stock
price. If the ratio falls below 1.0, then the market is saying that the firm is worth
less than what it owes, or in other words, insolvent.

9. RATIO E, SALES / TOTAL ASSETS
• is a measure of efficiency in that it describes the amount of sales generated by each
dollar of assets

10. A HEALTHY FIRM
It should now be easier to see why the Z-score is such a good measure of a
firm's financial health. A healthy firm
(A) maintains enough liquid assets to pay whatever bills are due,
(B) funds its growth with profits,
(C) invests in assets that generate profits for its owners,
(D) gets a vote of confidence from investors via its share price, and
(E) converts its investments into revenues for the company.

11. MANAGING A FINANCIAL TURNAROUND
• Predictive models can be turned “inside out” and used as internal
management tools to, in effect, reverse their predictions
• Some specific management tools which work are available in crisis
situations
• Activate an interactive, as opposed to a passive, approach to financial
decision making

12. MANAGING A FINANCIAL TURNAROUND
• Every financial analyst can assess the financial situation of enterprises generate
their own model.
• In terms of the results achieved financial and economic analysis financial manager
should be focused on one indicator summaries on which could prolong the situation
in which the company is located.

13. THE A SCORE MODEL
• Corporate failure models can be broadly divided into two groups:
• quantitative models, which are based largely on published financial information; and
• qualitative models, which are based on an internal assessment of the company concerned.
• Both types attempt to identify characteristics, whether financial or non-financial,
which can then be used to distinguish between surviving and failing companies.
• One of the most notable of qualitative models is the A score model attributed to
Argenti (1976)

14. A SCORE
• A Score suggest that the failure process follows a predictable sequence:
Defects
Mistakes
Symptoms

15. DEFECTS
• Defects can be divided into management weaknesses and accounting deficiencies as
follows:
Management weaknesses: Accounting deficiencies:
• autocratic chief executive (8)
• failure to separate role of chairman
and chief executive (4)
• passive board of directors (2)
• lack of balance of skills in management
team – financial, legal, marketing, etc
(4)
• weak finance director (2)
• lack of ‘management in depth’ (1)
• poor response to change (15)
• no budgetary control (3)
• no cash flow plans (3)
• no costing system (3)

16. • Each weakness/deficiency is given a mark (as shown) or given zero if the problem is
not present. The total mark for defects is 45, and Argenti suggests that a mark of 10
or less is satisfactory.
• If a company’s management is weak, then Argenti suggests that it will inevitably
make mistakes which may not become evident in the form of symptoms for a long
period of time. The failure sequence is assumed to take many years, possibly five or
more.

17. MISTAKES
The three main mistakes likely to occur (and attached scores) are:
1. high gearing – a company allows gearing to rise to such a level that one unfortunate
event can have disastrous consequences (15)
2. overtrading – this occurs when a company expands faster than its financing is
capable of supporting. The capital base can become too small and unbalanced (15)
3. the big project – any external/internal project, the failure of which would bring the
company down (15).
The suggested pass mark for mistakes is a maximum of 15.

18. SYMPTOMS
The final stage of the process occurs when the symptoms of failure become visible. Argenti classifies
such symptoms of failure using the following categories:
1. Financial signs – in the A score context, these appear only towards the end of the failure process, in
the last two years (4).
2. CREATIVE ACCOUNTING – optimistic statements are made to the public and figures are altered
(inventory valued higher, depreciation lower, etc). Because of this, the outsider may not recognize any
change, and failure, when it arrives, is therefore very rapid (4).
3. Non-financial signs – various signs include frozen management salaries, delayed capital
expenditure, falling market share, rising staff turnover (3).
4. Terminal signs – at the end of the failure process, the financial and non-financial signs become so
obvious that even the casual observer recognizes them (1).

19. THE OVERALL PASS MARK
The overall pass mark is 25. Companies scoring above this show many of the signs
preceding failure and should therefore cause concern. Even if the score is less than 25,
the sub-score can still be of interest. If, for example, a score over 10 is recorded in the
defects section, this may be a cause for concern, or a high score in the mistakes section
may suggest an incapable management. Usually, companies not at risk have fairly low
scores (0–18 being common), whereas those at risk usually score well above 25 (often
35–70).

20. ULTIMATE REASON FOR FAILURE
• Based on a study by the US Bank, the main reasons why businesses fail are:
• poor business planning (78% of businesses fail due to the lack of a well-developed
business plan)
• poor financial planning (82% of businesses failed due to poor cash flow management)
• poor marketing (Over 64% of the businesses surveyed in the failed under marketing
category)
• poor management (70% of businesses failed due to owners not recognising their failings
and not seeking help)

21. ULTIMATE REASON FOR FAILURE
• An interesting, alternative method of classifying reasons for failure is provided by
Richardson et al (1994), who use the analogy of frogs and tadpoles:
• Boiled frog failures (Adapting to change challenge)
• Drowned frog failures (managerial ambition and hyperactivity)
• Bullfrogs (Expensive show-offs)
• Tadpoles (start-up and growth challenge)

22. AVOIDING FAILURE
One of the more significant earlier works was by Ross and Kami (1973); they gave ‘Ten Commandments’ which, if broken,
could lead to failure:
1. You must have a strategy.
2. You must have controls.
3. The Board must participate.
4. You must avoid one-man-rule.
5. There must be management in depth.
6. Keep informed of, and react to, change.
7. The customer is king.
8. Do not misuse computers.
9. Do not manipulate your accounts.
10. Organize to meet employees’ needs