Validity of Altmans Z-Score Model in Predicting Bankruptcy in Recent Years

Abstract

INTRODUCTION Companies have been going bankrupt throughout history. Bankruptcies result in financial harm to investors and creditors and to the economy in general. Thus they have been a subject of study by accountants, in particular the topic of predicting bankruptcies. Accountants have come up with many models for predicting bankruptcies. Beaver (2005, 1966) used ratio analysis models while Altman (1968 2006) used discriminant analysis models and Ohlson (1980) used regression models among others. These models use various techniques to try to predict bankruptcy. They use financial statements and stock market data as variables in the models. Many of these models have been shown to be successful in predicting bankruptcy in many cases though none do it with complete accuracy. One of the oldest and most successful models of bankruptcy prediction is that of Altman (1968). His model is a multivariate model which combines financial statement and market value measures to calculate a score for a company. The Z-score may be used for bankruptcy prediction. The variables used in Altman's model are working capital, total assets, retained earnings, earnings before interest and taxes, market value of equity, and sales. Altman empirically tested his model by taking a sample of companies that had gone bankrupt and applying his model to their financial statements prior to bankruptcy to see if his model would have predicted their going bankrupt. Some later studies have shown the Altman model to be less successful in predicting bankruptcy and there has been criticism of the Z-score model. Grice (2001) has critiqued the Altman model and questioned its generizability to periods outside the test period and to industries outside the original sample. Economic conditions such as inflation, interest rates and credit availability may change over time thus making the Altman model less efficient in predicting bankruptcy. The purpose of the study will be to test the accuracy of Edward Altman's Z-Score model in a more recent period than in which it was developed and previously tested. Using data from companies that filed bankruptcy in the period from 200-2005, Z-scores will be calculated to test the accuracy of the model in predicting bankruptcies. The question is whether the Z-score model is an as accurate indicator for bankruptcy in a more recent period as it was in the 1960's. THE Z-SCORE MODEL The Altman Z-Score model from Altman (1968) is shown below: Z=1.2[X.sub.1] + 1.4[X.sub.2] + 3.3[X.sub.3] + 0.6[X.sub.4] + 0.999[X.sub.5] X1 = Current Assets--Current Liabilities/Total Assets X2 = Retained Earnings/Total Assets X3 = Earnings before Interest and Taxes/Total Assets Z = Overall Index or Score X4 = Market Value of Equity/Total Liabilities X5 = Sales/Total Assets The Z-Score Model has Zones of Discrimination that classify whether a company is in danger of going bankrupt or not. Companies classified in the Safe zone generally demonstrate a minimal chance of bankruptcy, while those in the Distress zone are in danger of falling into bankruptcy. Companies in the Grey zone have a moderate chance of going bankrupt but are not in as much danger as firms in the Distress zone. The Zones of Discrimination for the Z-Score Model are listed below: Zones of Discrimination: Original Z-Score Model (1968) Z > 2.99 Safe Zone 1.8 Z METHODOLOGY, DATA AND RESULTS The methodology consisted of taking a sample of bankrupt firms from Altman (2006) which had filed for bankruptcy between 2000 and 2005. The data needed to calculate Altman's Z-score were gathered from the Compustat database. Many companies in the original sample were deleted because of non-availability of data. The final sample consisted of 89 companies. …