Corporate Failure Prediction

Corporate Failure Prediction

Corporate failure prediction refers to the methods and tools used to assess whether a business is likely to enter financial distress, potentially leading to liquidation. It helps stakeholders, such as investors, creditors, and management, identify risks and make informed decisions about the future of the company. Several models exist to evaluate the likelihood of corporate failure, two prominent ones being Altman’s Z-Score and Argenti’s Failure Model.

Altman’s Z-Score

Devised by Edward Altman in 1968, the Altman Z-Score is a widely used financial model that employs multivariate analysis based on a company’s financial statements to predict the likelihood of bankruptcy. The model incorporates five financial ratios to generate a single score, known as the Z-Score, which indicates the financial health of the company.

• Z-Score Calculation:

  1. Working Capital / Total Assets
  2. Retained Earnings / Total Assets
  3. Earnings Before Interest and Tax (EBIT) / Total Assets
  4. Market Value of Equity / Total Liabilities
  5. Sales / Total Assets

  The formula for the Z-Score is:

  \[ Z = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E \]

  where:

  • \(A\) = Working Capital / Total Assets
  • \(B\) = Retained Earnings / Total Assets
  • \(C\) = Earnings Before Interest and Tax / Total Assets
  • \(D\) = Market Value of Equity / Total Liabilities
  • \(E\) = Sales / Total Assets

  An Altman Z-Score of 1.8 or less signifies a high probability of failure, while a score above 3.0 suggests financial stability.

Argenti’s Failure Model

Argenti’s Failure Model is another technique used to predict corporate failure. This model takes into account three main areas: defects of the company, management mistakes, and symptoms of failure. It assigns scores to different factors within these categories to evaluate the overall risk of failure.

Key Components:

1. Defects of the Company:

   • Over-gearing
   • Poor management practices
   • Lack of strategic planning

2. Management Mistakes:

   • Over-trading
   • Misallocation of resources
   • Failure to adapt to market changes

3. Symptoms of Failure:

   • Deteriorating cash flow
   • Increasing short-term debt
   • Declining profitability

Examples

1. Example 1 - Altman’s Z-Score: A manufacturing company with the following data:

   • Working Capital: $500,000
   • Total Assets: $2,000,000
   • Retained Earnings: $300,000
   • EBIT: $150,000
   • Market Value of Equity: $800,000
   • Total Liabilities: $600,000
   • Sales: $1,200,000

   Calculating the Z-Score: \[ Z = 1.2(0.25) + 1.4(0.15) + 3.3(0.075) + 0.6(1.33) + 1.0(0.6) = 0.3 + 0.21 + 0.2475 + 0.798 + 0.6 = 2.1555 \] With a Z-Score of 2.1555, the company is in a gray area but not immediately at high risk of failure.

2. Example 2 - Argenti’s Failure Model: A retail company exhibiting management mistakes such as over-trading and misallocation of resources, along with symptoms such as declining profitability and increasing debt levels, would score high on Argenti’s risk factors, indicating potential failure.

Frequently Asked Questions

Q1: What is corporate failure prediction? A: Corporate failure prediction involves using various techniques and models to assess the likelihood of a company collapsing or going into liquidation.

Q2: How does Altman’s Z-Score work? A: Altman’s Z-Score uses five key financial ratios from a company’s financial statements to calculate a score that predicts bankruptcy risk.

Q3: What is a significant Z-Score value for indicating bankruptcy risk? A: An Altman Z-Score of 1.8 or less suggests a high probability of bankruptcy, while a score above 3.0 indicates financial stability.

Q4: What areas does Argenti’s Failure Model evaluate? A: Argenti’s Failure Model evaluates defects of the company, management mistakes, and symptoms of failure to predict corporate collapse.

Related Terms

• Liquidation: The process of winding up a company by selling off its assets to pay creditors.
• Financial Statements: Records that outline the financial activities of a company, including the balance sheet, income statement, and cash flow statement.
• Multivariate Analysis: A statistical technique used to analyze data that originates from more than one variable.

Online References

• Investopedia on Altman’s Z-Score
• Corporate Finance Institute on Financial Distress
• IRS Business Income and Receipts

Suggested Books

1. Financial Statement Analysis and Security Valuation by Stephen Penman
2. Corporate Finance: Theory and Practice by Aswath Damodaran
3. The Intelligent Investor by Benjamin Graham

Accounting Basics: “Corporate Failure Prediction” Fundamentals Quiz

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