Edward i (1)

Presented by-
Priyanka Jaiswal.
MBA-IB
Roll-No- 11(Eleven)
*

*Altman developed an empirical model to predict bankruptcy using
multiple discriminant analysis (MDA).
*MDA is a statistical technique used to classify an observation into
one of several a priori grouping a dependent upon the
observation’s individual characteristics.
*It is used primarily to classify and/or make predictions in
problems where the dependent variable appears in qualitative
form.
*Examples: male or female,bankrupt or non-bankrupt.

*The first step is to establish explicit group classifications. The
number of original group can be two or more.
*Data (balance sheet and income statement) are collected for the
objects in the group after the groups are established.
*MDA determines a set of discriminant co-efficients.
*When these co-efficients are applied to the actual ratio, a basis
for classification into one of the mutually exclusive groupings
exists.
*The discriminant function of the firm:
Z=푣1푥1 + 푣2푥2 + ⋯ + 푣푛푥푛.
Transforms individual variable values to a single discriminant
score or Z value which is then used to classify the object.
Where, v1,v2,…….,vn = discriminant co-efficients
X1,x2,….,xn = independent variables.

*A list of 22 variables were classified into 5 standard ratio categories,
including liquidity, profitability, leverage, solvency and activity ratios.
*The final 5 ratios selected by Altman:
1) Working Capital/total assets:
It is a measure of the net liquid assets of the firm relative to the total
capitalization. It is defined as the difference between current assets and
current liabilities. Liquidity and size characteristics were explicitly
considered.
2) Retained Earnings/Total Assets:
this is a measure of cumulative profitability over time. The age of a
firm is implicitly considered in this ratio.
3) Earnings before interest and taxes/Total assets:
It is a measure of the true productivity of the firm’s assets,
abstracting from any tax or leverage factors. Since a firm’s ultimate
existence is based on the earning power of its assets, this ratio appears to
be relevant to studies dealing with corporate failure.

4) Market Value of equity/ Book value of total debt:
Equity is measured by the combined market value of equity and
preference shares while debt includes both current and long-term debts.
This measure shows how much the firm’s assets can decline in value
before the liabilities exceed the assets and the firm becomes insolvent.
5) Sales/ Total assets:
The capital turnover ratio is a standard financial ratio indicating the
sales generating ability of the firm’s assets. It is one measure of
management’s capability in dealing with competitive conditions.
It may be stated that by selecting the above 5 ratios Altman
attempted to consider financial problems and operating problems.
His final discriminant function was as follows;
Z=0.012 x1 + 0.014 x2 + 0.033 x3 + 0.006x4 + 0.999x5

A score of 2.675 was established as a cut-off point by Altman. His zone
of ignorance was from Z=1.81 to Z=2.99. This indicate that while a
company was likely to go bankrupt (if below 2.675) or likely to remain a
going concern (above 2.675), there was the possibility that an error in
classification could exist for a score within this zone.

*Gupta’s general approach to the problem of evaluating the survival
strength of companies was derived from the concept of “marginal” firm.
The strength of a firm to survive over long periods, and specially
through periods of different business conditions, lies in its having a
strong relative position within its industry.
*

*Out of all 63, 7 of the accounting ratios were selected by him and
classified into:
a) Profitability Ratios
b) Balance Sheet Ratios
which measure, directly or indirectly, the strength of equity.
Each of these two groups was sub-divided into several categories.
According to him, the two best ratios of about equal merits were: EBDIT
to sales, OCF to sales.
The next best three ratios were: EBDIT to total assets, OCF to total assets
and EBDIT to estimated debt service burden.
All the above 5 ratios showed a high degree of predictive power, as
reflected in low percentage classification error, at least wo or three years
before a near bankruptcy stage.

*Gupta’s findings point out that for understanding of sickness as well
as for its early symptoms, one has to look more to the operating
statement than to the balance sheet as the predictive ability of the
best balance sheet ratios was much less than that of best profitability
ratios.
*Gupta’s results also point to the existence of definite association
between incidence of sickness and inadequacy of equity base.

Edward i (1)

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