Z Score Model

ACCA P5 Advance Performance Management

Earlier we looked at Argenti’s A Score which is qualitative model for prediction of business failure. Here we will go through quantitative model for prediction of business failure.

Importance of cash-flow, liquidity vs profitability and gearings are some core areas of financial management. Here we see how these financial measures help predict business failure.

William Beaver (1966) pioneered the prediction model which is based on study of financial ratios in isolation. For each ratio, an optimal and cut off point was identified where the percentage of misclassification was minimised. Misclassification could be either classify failing firm as non-failing firm or non-failing firm as failing firm.

Quantitative models are fundamentally dependent on financial data. These models are based on published financial information and analyse various sets of financial ratios (relative ratios) from past surviving and failing companies, and establish a relationship between financial ratios to predict companies to fail in future. In the model ratios are given different rating (an absolute value). Absolute values together with relative ratios are then related into a function and then the range is defined for the function where business will fail and survive.

Z-score model

Ratio	Relative Figure (RF)	Absolute Value (AV)	Product = RF*AV
Liquidity	Working capital / Total assets	1.2
Solvency	Retained earnings /Total assets	1.4
Profitability	EBIT / Total assets	3.3
Leverage	Market value of equity/Total liabilities	0.6
Activity	Sales /Total assets	1.0
			Total

The score indicates the likelihood of failure:

Ø  Less than 1.81 – danger and possibly heading towards bankruptcy

Ø  Between 1.81 and 2.99 – need further investigation

Ø  Greater than 2.99 – financially sound

Use relative index

Limitation of qualitative models:

Ø  Rates companies too low

Ø  Only good predictor in short run

Ø  Carries risk that financial ratios are manipulated

Ø  Does not account for sudden market shift (transformational  change)