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Interest in insolvency prediction has long been confined to academics, with most of the

published material restricted to business and accounting journals specializing in esoteric

and complicated subjects. A possible reason why insolvency prediction models have not

gained greater use in the business community is because it has been difficult to calculate

the results. With the wide spread use of personal computers, the utilization of an

insolvency prediction model is now practical and available to all. Now may be the time

when prediction models come into their own!

Four software programmes are reviewed here using five different prediction models. All

of the models reviewed here, but one, were developed using the statistical technique,

step-wise multiple discriminate analysis. This statistical technique gives weights to

financial ratios used to best differentiate or discriminate between failed and successful

companies. For example, 22 financial ratios were tested in developing the Altman Model

(1968). 66 companies were used - 33 failed and 33 successful. The first result was a

formula with 22 functions. The function that contributed the least to discriminating

between the failed and successful companies was dropped and the statistical software was

run again. This was repeated over and over each time dropping the ratio which least

contributed to discriminating between the failed and successful companies. In the case of

the Altman model, five functions remained.

The software we have reviewed here are easy to operate and give quick read outs. We

have not evaluated the models compared with each other because it is impossible to say,

in this kind of review, that one model is better or more accurate than another. One of the

great problems in developing and testing prediction models is that it is very difficult to

gather data on matched sets of failed and successful companies.

Some Words of Caution! All developers of prediction models warn that the technique

should be considered as just another tool of the analyst and that it is not intended to

replace experienced and informed personal evaluation. Perhaps the best use of any of

these models is as a "filter" to identify companies requiring further review or to establish

a trend for a company over a number of years. If, for example, the trend for a company

over a number of years is downward then that company has problems, which if caught in

time, could be corrected to allow the company to survive.

If bankers can identify companies in danger of failure sufficiently far in advance, then

corrective action can be taken. The banker can:

2. Encourage the company to identify its problems and take steps to rectify those

problems.

3. Encourage the principals of the company to inject more capital into the business.

4. Encourage the company to seek other financing.

BEAVER MODEL (1967 & 1968)

William Beaver (1967), one of the earliest researchers, was the first to use statistical

technique of univariate analysis to predict corporate failure on the basis of mean

values of thirty different financial ratios which were later reduced to fourteen

ratios. Beaver used a dichotomous classification test on two samples of firms (79

bankrupt firms and 79 non failed firms of approximately the same size and

industry group) based on the calculated ratios to discriminate between failed and

non-failed firms for as long as five years prior to failure. Beaver discovered that

there was significant difference between the financial ratios of failed firms and

non failed firms. Not only were they lower but deteriorated as failure approaches.

He then concluded that of the variables analyzed cash flow/total debt was the

single most important factor to consider in predicting failure. Beaver’s model was

able to accurately classify 78% and 87% of the sample of firms five years and one

year before failure respectively.

Edward I. Altman (1968) is the dean of insolvency predictors. He was the first person to

successfully use step-wise multiple discriminate analysis to develop a prediction model

with a high degree of accuracy. Using the sample of 66 companies, 33 failed and 33

successful, Altman's model achieved an accuracy rate of 95.0%. Altman's model takes the

following form -:

Where:

X2=Retained Earnings/Total Assets

X3=Earnings Before Interest and Taxes/Total Assets

X4=Market Value of Equity/Book Value of Total Liabilities

X5=Sales/Total Assets

SPRINGATE (CANADIAN - 1978)

This model was developed in 1978 at S.F.U. by Gordon L.V. Springate; following

procedures developed by Altman in the U.S. Springate used step-wise multiple

discriminate analysis to select four out of 19 popular financial ratios that best

distinguished between sound business and those that actually failed. The Springate model

takes the following form -:

Where

X1 = Working Capital/Total Assets

X2 = Net Profit before Interest and Taxes/Total Assets

X3 = Net Profit before Taxes/Current Liabilities

X4 = Sales/Total Assets

This model achieved an accuracy rate of 92.5% using the 40 companies tested by

Springate. Botheras (1979) tested the Springate Model on 50 companies with an average

asset size of $2.5 million and found an 88.0% accuracy rate. Sands (1980) tested the

Springate Model on 24 companies with an average asset size of $63.4 million and found

an accuracy rate of 83.3%.

ratios applied to a sample of 60 companies -30 failed and 30 successful. The average

asset size of these firms was $455,000. The model takes the following form -:

H= 5.528 (V1) + 0.212 (V2) + 0.073 (V3) + 1.270 (V4) - 0.120 (V5) + 2.335 (V6) + 0.575

(V7) + 1.083 (V8) + 0.894 (V9) - 6.075

Where

V1 = Retained Earning/Total Assets

V2 = Sales/Total Assets

V3 = EBT/Equity

V4 = Cash Flow/Total Debt

V5 = Debt/Total Assets

V6 = Current Liabilities/Total Assets

V7 = Log Tangible Total Assets

V8 = Working Capital/Total Debt

V9 = Log EBIT/Interest

Fulmer reported a 98% accuracy rate in classifying the test companies one year prior to

failure and an average 81% accuracy rate more than one year prior to bankruptcy.

This is the only business failure prediction method outlined here that was not developed

using multiple discriminate analysis. This system was developed by William Blasztk in

1984. The essence of the system is that the financial ratios for the company to be

evaluated are calculated, weighted and then compared with ratios for average companies

in that same industry as given by Dunn & Bradstreet. One of this method's strengths is

that it does compare the company being evaluated with companies in the same industry.

This model is recommended by the Ordre des compatables agrees des Quebec (Quebec

CA's) and according to its developer is used by over 1,000 CA's in Quebec.

This model was developed under the direction of Jean Legault of the University of

Quebec at Montreal, using step-wise multiple discriminate analysis. Thirty financial

ratios were analyzed in a sample of 173 Quebec manufacturing businesses having annual

sales ranging between $1-20 million.

+ 4.5080 (earnings before taxes and extraordinary items

+ financial expenses (1)/total assets (1)) +

0.3936 (sales (2)/total assets (2)) - 2.7616

* Shareholders' investments are calculated by adding to shareholders' equity the net

debt owing to directors.

This model, as reported in Bilanas (1987), has an average reliability rate of 83% and is

restricted to evaluating manufacturing companies.

REFERENCES

1. Altman, Edward I., "Financial Ratios, Discriminant Analysis and the Prediction of

Corporate Bankruptcy". Journal of Finance, (September 1968): pp. 589-609.

2. Botheras, Donald A., "Use of a Business Failure Prediction Model for Evaluating

Potential and Existing Credit Risk". Unpublished M.B.A. Research Project,

Simon Fraser University, March, 1979.

3. "C.A. - Score, A Warning System for Small Business Failures", Bilanas (June

1987): pp. 29-31.

4. Fulmer, John G. Jr., Moon, James E., Gavin, Thomas A., Erwin, Michael J., "A

Bankruptcy Classification Model For Small Firms". Journal of Commercial Bank

Lending (July 1984): pp. 25-37.

5. Sands, Earl Gordon, "Business Failure Prediction and the Efficient Market

Hypothesis". Unpublished M.B.A. Research Project, Simon Fraser University,

November 1980.

6. Sands, Earl G., Gordon L.V. Springate, and Turgut Var, "Predicting Business

Failures". CGA Magazine (May 1983): pp. 24-27.

7. Springate, Gordon L.V., "Predicting the Possibility of Failure in a Canadian

Firm". Unpublished M.B.A. Research Project, Simon Fraser University, January

1978.

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The failure of a business firm is an event which can produce substantial losses to

creditors and stockholders. Therefore, a model which predicts potential business failures

as early as possible would serve to reduce such losers by providing ample warning to all

interested parties. This was the sufficient motivation for Beaver (1967, 1968) and Altman

(1968) to develop models for predicting business failure based on the financial reports of

firms. Thus, attempts to develop bankruptcy prediction models began seriously sometime

in the late 1960's and continue through today. At least three distinct types of models have

been used to predict bankruptcy:

1) Statistical models (primarily, multiple discriminate analyses [MDA]), and

conditional logit regression analyses,

research published by university professors. Commercial banks, public accounting firms

and other institutional entities (bond ratings agencies, for example) appear to be the

primary beneficiaries of this research, since they can use the information to minimize

their exposure to potential client failures.

While continuing research has been ongoing for almost thirty years, it is interesting to

note that no unified well-specified theory of how and why corporations fail has yet

been developed. The available statistical models derive merely from the statistical

optimization of a set of ratios. As stated by Wilcox(1), the "lack of conceptual framework

results in the limited amount of available data on bankrupt firms being statistically 'used

up' by the search before a useful generalization emerges."

How useful are these models? Almost universally, the decision criterion used to evaluate

the usefulness of the models has been how well they classify a company as bankrupt or

non-bankrupt compared to the company's actual status known after-the-fact (that is ex

post). Most of the studies consider a type I error as the classification of a failed company

as healthy, and consider a type II error as the classification of a healthy company as

failed. In general type I errors are considered more costly to most users than type II

errors. The usefulness of fail/nonfail prediction models is suggested by Ohlson(2):

...real world problems concern themselves with choices which have a richer set of

possible outcomes. No decision problem I can think of has a payoff space which is

partitioned naturally into the binary status bankruptcy versus non-bankruptcy...I have

also refrained from making inferences regarding the relative usefulness of alternative

models, ratios and predictive systems... Most of the analysis should simply be viewed as

descriptive statistics - which may, to some extent, include estimated prediction error-

rates - and no "theories" of bankruptcy or usefulness of financial ratios are tested.

be used to predict failure.

The early history of researchers' attempts to classify and predict business failure (and

bankruptcy) is well documented in Edward Altman's seminal 1983 book, Corporate

Financial Distress(3). There appears to be no consensus on what constitutes business

failure. However, most businesses are considered to have failed once they have entered

formal bankruptcy proceedings.

Failure prediction models use different approaches to predict failure. Beaver(4) (1967),

one of the earliest researchers, used a univariate analysis of a number of financial ratios

to discriminate between failed and non-failed firms for as long as five years prior to

failure. Of the variables Beaver analyzed, he concluded that cash flow/total debt was the

single most important factor to consider in predicting failure. Beaver's work set the stage

for the multivariate analyses developed by Altman and others.

Possibly the most famous failure prediction model is Altman's Z-Score Model. Based on

multiple discriminate analysis (MDA), the model predicts a company's financial health

based on a linear discriminant function of the form:

Z=0.012X1+0.014X2+0.033X3+0.006X4+0.999X5

Where:

X1=working capital/total assets

X2=retained earnings/total assets

X3=earnings before interest and taxes/total assets

X4=market value of equity/book value of total liabilities

X5=sales/total assets

manufacturing companies with 33 firms in each of two matched-pair groups. The

bankruptcy group consisted of companies that filed a bankruptcy petition under Chapter

X of the United States bankruptcy act from 1946 through 1965. Based on the sample, all

firms having a Z-Score greater than 2.99 clearly fell into the non-bankruptcy sector,

while those firms having a Z-Score below 1.81 were bankrupt.

However it was discovered that the predictive ability of the model declined rapidly as the

number of years prior to failure increased.

Altman subsequently developed a revised Z-Score model (with revised coefficients and

Z-Score cut-offs) which dropped variables X4 and X5 (above) and replaced them with a

new variable X4 = net worth (book value)/total liabilities. The X5 variable was allegedly

dropped to minimize potential industry effects related to asset turnover.

Around 1977, Altman developed jointly with a private financial firm (ZETA Services,

Inc.) a revised seven-variable ZETA model based on a combined sample of 113

manufacturers and retailers. The ZETA model is allegedly "far more accurate in

bankruptcy classification in years 2 through 5 with the initial year's accuracy about

equal." However, the coefficients of the model are not specified (without retaining ZETA

Services). The ZETA model is based on the following variables:

• return on assets

• stability of earnings

• debt service

• cumulative profitability

• liquidity/current ratio

• capitalization (five year average of total market value)

• size (total tangible assets)

Many additional bankruptcy prediction models have been developed since the work of

Beaver and Altman. Lev (1974)(5), Deakin (1972)(6), Ohlson (1980)(7), Taffler (1982)

(8), Platt & Platt (1980)(9), Gilbert, Menon, and Schwartz (1990)(10), and Koh and

Killough (1990)(11) amongst others have continued to refine the development of

multivariate statistical models. Almost all of these traditional models have been either

matched-pair multi-discriminate models (such as Altman's) or logit models (such as

Ohlson's). A 1997 study by Begley, Ming and Watts(12) concludes:

indicator of financial distress, its strong performance in this study supports its use as a

preferred model.

approach to bankruptcy prediction. Under this approach, bankruptcy is probable when a

company's net liquidation value (NLV) becomes negative. Net liquidation value is

defined as total asset liquidation value less total liabilities. From one period to the next, a

company's NLV is increased by cash inflows and decreased by cash outflows during the

period. Wilcox combined the cash inflows and outflows and defined them as "adjusted

cash flow." All other things being equal, the probability of a company's failure increases,

the smaller the company's beginning NLV, the smaller the company's adjusted (net) cash

flow, and the larger the variation of the company's adjusted cash flow over time. Wilcox

uses the gambler's ruin formula (Feller, 1968) to show that a company's risk of failure is

dependent on 1) the above factors plus 2) the size of the company's adjusted cash flow "at

risk" each period (i.e., the size of the company's bet).

gambler's ruin model to develop a safety index. Based on input concerning the variability

of "expected contribution margin amounts," the index can be used to predict the point in

time when a company's ruin is most likely to occur (called first passage time).

The statistics used in gambler's ruin approaches are somewhat formidable (especially to

the average business reader). However, both Wilcox and Vinso richly describe some of

the factors which most affect business failure. For example, Wilcox states:

The (cash) inflow rate ... can be increased through higher average return on investment.

However, having a major impact here usually requires long-term changes in strategic

position. This is difficult to control over a short time period except by divestitures of

peripheral unprofitable businesses...The average outflow rate is controlled by managing

the average growth rate of corporate assets. Effective capital budgeting ... requires

resource allocation emphasizing those business units which have the highest future

payoff.

The size of the bet is the least understood factor in financial risk. Yet management has

substantial control over it. Variability in liquidity flows governs the size of the bet. This

variability can be managed through dividend policy, through limiting earning variability

and investment variability, and through controlling the co-variation between profits and

investments...True earnings smoothing is attained by control of exposure to volatile

industries, diversification, and improved strategic position. (Emphasis added)

Vinso supports Wilcox's emphasis on cash flow processes and stresses the importance of

debt capacity:

Before deriving a mathematical model for determining the risk of ruin, it is necessary to

describe the process. (First), a firm has some pool of resources at time = 0 of some size

U0, which are available to prevent ruin (similar to Wilcox's beginning NAV). (Then),

earnings come to (the) firm from revenue(s)...less the costs incurred in producing (the

revenues)

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