3. The Need for Comparison
• Merely calculating ratios will not tell us very
much about the financial health of the company
• For example, if a ratio revealed that a business
was turning over inventory every 25 days, it
would not be possible to deduce from this
information alone if the performance was good
or bad
• It is only when we benchmark with other
companies over a series of observation points,
that the information can be evaluated and
interpreted
4. Altman Z-Score
• Altman’s (1968) Z‐Score model was developed by NYU
Stern Professor, Edward Altman
• Attempts to overcome the problems with using individual
ratios led to conflicting indications
• The significance of the Altman model is that it enables the
level of solvency of a firm to be determined (known as the
“Z-score’)
• The score can be used to infer the probability of default and
the default rate
• Firms with a z-score greater than 2.99 are seen as solvent
• Firms between 1.81 and 2.99 are in the “gray” zone
• Firms with a z-score below 1.81 are seen as being in a
distressed state
5. Altman cont’d
• Uses accounting variables
• The Altman z-score is comprised of five ratiosrepresenting liquidity,solvency, and
profitability
Formula is:
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5 Z-Score for Manufacturing
Z= 0.717X1 +0.847X2 + 3.107X3 + 0.42X4 + 0.998X5 Z-Score for Private Companies*
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 Z-Score for Z Score for Non-manufacturers
• X1 = Working Capital / Total Assets
• X2 = Retained Earnings / Total Assets
• X3 = EBIT / Total Assets
• X4 = Market Capitalization / Total Liabilities
• X5 = Sales/ Total Asset
Zonesof Discrimination
• Z' > 2.9 ‐“Safe” Zone
• 1.81 < Z' < 2. 9 ‐“Grey” Zone
• Z' < 1.81 ‐“Distress” Zone
*X4 for Private companies = BookValue of Equity/Total Liabilities
7. • As can be seen in Figure, all the supermarkets have a high
enough Z-score from 2010 to 2014 and need not worry about
the probability of default
• What may be of concern to Tesco, however, is its overall
financial strengthin comparison to its competitors
• A closer look at the trend lines in the Figure shows that Tesco
Z-score has consistentlydecreased since 2010 and was at all
material times below those of its competitors
• As a matter of fact, from 2010 to 2013, Sainsburys and
Morrisons’ financial performances were relatively robust as is
evident in their trend lines being in the safe zone for those
years
8. Quantitative Assessment: Ohlson’s logit model
• Ohlson’s (1980) model is generally considered to be
one of the best representation of financial distress
models
• Uses “multiple lenses of perception”
• Adopts the practice of using multiple variables to fully
capture the significance of a particular financial issue
• The model uses financial ratios to account for
company size, capital structure, return on assets, and
current liquidity, among others
9. This model formula is:
Y = -1.3 – 0.4Y1 + 6.0 Y2 – 1.4Y3 + 0.8Y4 – 2.4 Y5 – 1.8Y6 + 0.3 Y7 – 1.7 Y8 –0.5Y9
Where:
• Y = overall index:
• Y1 = log (total assets/GNPPrice-level index)
• Y2= total liabilities/total assets
• Y3 = working capital/total assets
• Y4= current liabilities/current assets
• Y5 = one if total liabilities exceed total assets, zero otherwise
• Y6 = net income/total assets
• Y7 = funds provided by operations/total liabilities
• Y8 = one if net income was negative for the last two years, zero otherwise
• Y9 = change in net income
10. • All in all, the Ohlson’s model depicts the six important
financial ratios being consistent withthe existing literature
(see Altman, 1968)
• Ohlson’s approach maps the value to a probability
bounded between 0 and 1
• The Ohlson O-score measures financial distress and is
considered to be a much more robust measure to predict
corporate failure than the Altman Z-score (Young and
Coleman, 2009)
• Contrary to the Z-score, the higher the O-score, the worse it
is expected that the company's financial performance will
be (Ohlson, 1980)
• Source: Kleinert (2014)
12. • As can be seen in the Figure, the shaded gray area is above the safety line
and indicates that the company is in financial distress
• Unlike the Z-score, the O- score reveals more erratic performance for
Tesco
• From 2010 to 2012, Tesco's O-score has been just in the safety zone of 0.5,
whilst its competitors were comfortably safe
• Tesco's financial health began to deteriorate in the latter part of 2012 as
its O-score rise above the safety line (in contrast to its competitors), and
– then hoversaround in the safe zone about the time the profit overstatement
was announcedin September of 2014
13. Problems Associated with Using Financial Ratios to
Predict Failure
• These models are all based on accountingdata
• Principal problems lies with the inadequacy of
source data
– i.e., from the income statement and balance sheet
(Chadwick, 2001)
– The use of accounting concepts and the manner in
which professional judgement is applied can lead
to inconsistency in the calculation of the final
figures (Bowen, Davis & Matsumoto, 2005)
14. • It must be remember that ratio calculations
are based on
“financial statements and that the results of the
financial analysis are dependent on the quality of
those underlying statements” (McLaney & Atrill,
2002: 232-233)
• Subsequently,ratios will inherit the limitations
of the financial statements that they are
based upon
15. • Inter firm comparisons can be problematic and very
often lead to inconsistencies in financial statement
analysis (Kellogg & Kellogg, 1991)
• An important issue is to consider the degree of
conservatism that each business adopts in the
reporting of profit (McLaney & Atrill, 2002)
• In the interpretation
– it is important to keep in mind that the subsequent analyses are
based on profit and loss account and balance sheets
– which are subject to the limitations associated with historical cost
accounting (Gillespie et al., 2004)
16. • More specifically
– inflation
– specific price changes, and
– different bases of evaluation are all likely to
distort comparison
• What happens through the period of the
asset’s working life therefore appears to be
irrelevant (Chadwick, 2001)
17. • In summary, financial indicators of performance tend to show
what has happened rather than what is going to happen to
drive the creation of wealth
• The analysis evaluates what the companies are expected to
achieve
• This is particularly important in firms where management is
concentrating on achieving short-term set targets
• Traditional financial indicators using ratios or even Net
Present Value (NPV) and Internal Rate of Return (IRR)
– can give misleading signals deliberately or by accident, particularly in
the short-term (Brealey, Allen, & Myers, 2009).
