The computation and analysis of certain ratios based on the information taken from financial statements allow the analyst to predict sickness or business failure.
But the ratios are considered independent of each other, will not permit to express the whole situation in a single measure.
Therefore, it would be more useful if the important ratios are combined together to measure the probability of sickness or insolvency.
To overcome this difficulty multiple discriminant analysis is used.
Edward I. Altman (1968) developed Z score model in order to detect the financial health of industrial units with a view to prevent the industrial sickness.
The model was developed basing on empirical studies, to predict the sickness of a unit in advance.
The model is also called as ‘multiple discriminant analysis (MDA)’. It is a linear analysis used to develop with five variables.
The MDA computes the discriminant coefficient while the independent variables are the actual values taken from the financial statements.
Altman Z score model is expressed as under:
Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5
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 debt
X5 = Sales/Total assets
Z score model can be analyzed as follows:
(i) Sickness is predicted basing on value of Z
(ii) If Z score is more than 2.99 – there is no danger of bankruptcy.
(iii) If Z score is below 1.81 – there is a definite failure.
(iv) If Z score is between 1.81 and 2.99 – it shows the grey area.
Altman developed a guideline for Z score:
(i) If score is above 2.675 – firms can be classified as financially sound.
(ii) If score is below 2.675 – the firm is heading towards bankruptcy.
Therefore, the lower the Z score, there is a greater possibility of bankruptcy and vice versa.
Altman’s model has established itself as the leading multivariate predictor model of corporate failure and it has been the subject of numerous tests around the world.
It would be useful to employ the Altman model in evaluating Indian firms and endeavour to establish the reliability of the model.
The cut off point for the Z score should be altered from that established in the original study.