Altman's model for predicting business failure: case study of HAFED.

Kumar, Jitender ; Pal, Karam ; Mahapatra, S.N. 等

[ILLUSTRATION OMITTED]

I Introduction

Financial reporting has become a crucial component of communication between a business and its stakeholders. Reporting financial information to external stakeholders not involved in the day-to-day management of the business requires a carefully balanced process of extracting the key features while preserving the essential, integrity, objectivity and core of information. The published annual report of the concerned organization is the most important way for an organization to communicate with its external stakeholders. Even when the highlights of the annual report have been pre-announced to interested parties, the document remains as the key to guarantee on the financial position and past performance of the organization (Weetman, 1996).

Concept and Importance of Financial Analysis

Financial analysis shed light for better understanding and evaluating the results of business operations and explaining how healthy a business is doing. In addition, financial statement analysis can help creditors, investors, and managers answer the following questions: Can the company pay the interest and principal on its debt? Does the company rely too much on non-owner financing? Does the company earn an adequate return on invested capital? Is the gross profit margin growing or shrinking? Does the company effectively use non-owner financing? Are costs under control? Is the company's market rising or shrinking? Do observed changes reproduce opportunities or threats? Is the allocation of investment across different assets too high or too low? Therefore, financial analysis may be defined as "the critical process which aims to evaluate the current and past financial positions and the results of operations of a firm, with the primary objective of determining the best possible estimates and predictions about future conditions and performances" (Samules et. al. 1995).

The analysis of a firm's financial statements is undertaken with the reason of extracting significant information relating to firm's objectives, profitability, efficiency and degree of risk. This is achieved by using ratios relating to key financial variables and analysis of the statements and the comments relating to them. Because ratio analysis employs financial data taken from the firm's balance sheet, statement of retained earnings, and Profit and loss A/c. These reports and their interrelations must be mastered to fully understand the significance of the various financial ratios (Betker, 1995).

The basic financial statement includes three important documents (A+B+C) namely:

A) Balance sheet, which shows the firm's financial position at a specific time. It has two sides namely assets and liabilities:

A.1 Assets:

i. Assets prearranged in order of liquidity

ii. Current assets transformed to cash within one year or operating cycle whichever is longer.

iii. Fixed assets tangible resources of a relatively enduring nature that are being used in the business and not intended for sale.

A.2 Liabilities:

i. Current liabilities must be paid off within one year or operating cycle whichever is longer.

ii. Long-term debts with maturity larger than one year.

iii. Stockholders equity represents ownership of the firm.

B) The profit and loss A/c reports the income and expenses of operations during a period of time.

C) The statement of retained earnings shows the amount of net income reinvested in the business. It should be mentioned here that retained earnings shows the amount of net income reinvested over a time of years and retained earnings are not typically held in cash, but invested in other assets of the firm.

The information contained in the firm's financial statements is momentous. Accounts are prepared for the firm's financial year and only become available some months after the end of that year (Beranek, et. al. 1996).

Organization Profile of HAFED

To serve the economic interests of the farmers of Haryana state in terms of viable and efficient support "The Haryana state co-operative supply and marketing federation limited", popularly known as HAFED, come into being on 1st November 1966 with the formation of the Haryana state. HAFED's activities diversified into food grains' procurement, warehousing, cold storage, agro-processing and marketing of economic status of farmers and the rural poor. HAFED has also promoted two new co-operative sugar mills at Sirsa and Gohana, an animal feeds plant at Saktakhera, two modern rice mills at Ding and Kalanwali and an oil mills at Narnaul. The formation of the organization was expected to facilitate the farmers' cooperative societies, consumers etc. It is engaged in comprehensive activities. Starting from ensuring remunerative prices to the growers, to provide quality products to the consumers, in grower's sector, HAFED service package includes supply of quality agricultures inputs, adequate marketing support by being an assured and dependable buyer for their produce and looking after the farmer's needs at all levels (www.hafed.nic.in).

Literature Review

Many of the research studies have been conducted, over the period to evaluate the financial position of the different organizations with the help of the various ratios and predicted failure in advance by applying Z-score Altman and other bankruptcy prediction models. Gerantonis, et. al. (2009) checked whether Z-score Altman model, can predict correctly company failures. They found that Altman model performs well in predicting failure. Similarly Alrawi, et. al. (2008) used Altman Z-score and ratio analysis approaches to conclude their views why the firms under study went bankrupt? They concluded that Altman's model may be used as an indicator and perhaps evidence to determine the firm's bankruptcy in the future. But, criticizing Altman's model Aziz and Dar (2006) illustrate that the multiple discriminate analysis (MDA) and the Logit models are highly accurate with error rates of 15 percent each. While the MDA model uses a bankruptcy score calculated by a linear equation to determine the probability of bankruptcy, the Logit model predicts the probability "as a dichotomous dependent variable that is a function of a vector of explanatory variables". Other than, Krishna (2005) used Z-score Altman model to measure the financial distress of IDBI and concluded that IDBI is likely to become insolvent in the years to come. For verifying the worth of ratios Bagchi (2004) analyzed about practical implication of accounting ratios in risk evaluation and concluded that accounting ratios are still dominant factors in the matter of credit risk evaluation and followed by Selvam, et. al. (2004) had revealed about Cement industry's financial health with special reference to India Cements Limited. Similarly, Mulla (2002) made a study in textile mill with the help of Z score model for evaluating the financial health with five weighted ratios and afterward Ritu (2002) made a comprehensive attempt to assess the financial health of public sector units in India by applying Altman's Z-score model. Data was collected for the period of 10 years for the sample of 24 public limited companies. She found that the some industries are in very healthy zone, some in healthy zone and some in bankruptcy zone and keeping in view the PSU's, which would be designated as bankrupt and 'certain' to fail, thus need to be privatized. On the same track, Gilker (1999) had found public enterprises (in the central as well as state sector) have failed to overcome the expectations of the society but most of them now proved white elephants. He examined the overall financial performance of a central public sector unit operating in the JandK state for last several years in different phases of its operations; identifies the various areas contributing towards the unsatisfactory operational performance of the unit, attempts to predict the financial health and viability of the unit in the year to come by testing the technique of 'Altman's Z-score analysis and finally prevails for the privatization of the unit and such other enterprises in the state sector with an objective to improve their operational efficiency, effectiveness, productivity and profitability. But, Martikainen (1991) advocated that the marginal utility of evaluating a large number of different financial ratios might be quite low. Instead, decision makers might be better off by concentrating on a relatively low number of key financial ratios of companies. Directly or indirectly Martikainen have supported the Altman model because he also has selected some important ratios for the application of this model. Later, Gupta (1983) made a comprehensive attempt by testing 56 ratios in two independent test samples of textiles and non-textiles firms. He found that the predictive power of traditional liquidity ratio showed an average classification error almost three times greater than profitability ratios, in case of textiles companies. This ratio could be attributed to window dressing and disclosures of some liability items. Operating cash flow to sales ratios turned out to be more important in this study.

The brief review of previous studies on the use of financial ratios, Z-score Altman model and other bankruptcy models will provide an ample testimony and gave a hint for the evaluation of the financial performance of HAFED. Further, review also highlighted that financial viability prediction is very important issue especially for public enterprises.

Objectives of Study

The objectives of the study are:

i. To analyze the liquidity, solvency, efficiency and profitability of HAFED.

ii. To examine the financial viability of HAFED.

iii. To suggest the policy makers for the further improvement of HAFED.

Research Methodology

The research methodology included:

i. Financial data for five years (2004-05 to 2008-09) have been obtained from published annual reports of HAFED.

ii. Select financial ratios analysis of HAFED for the period of five years. It has been used to review profitability and risk, current and future financial position.

iii. Finally, we used Z-score Altman insolvency prediction model to determine the financial viability (developed by Prof. Edward Altman of New York University in 1968) of HAFED. Other bankruptcy prediction models also exist, but we have used Altman's model because other models are complex and most are proprietary. The Z-score for predicting bankruptcy is a multivariate formula for the measurement of the financial health of a company and a powerful diagnostic tool that forecast the probability of a company entering bankruptcy within two year period. Studies measuring the effectiveness of the Z-score have shown that the model has 70 percent--80 percent reliability. Altman's equation did a good job at distinguishing bankrupt and non-bankrupt firms. Further, this model may be used for credit evaluation, merger and acquisition analysis, turnaround management, insurance underwriting, and corporate governance etc. Model is based on multiple discriminatory analyses indicates towards company failure or insolvency and it is not complicated. Model combines five different financial ratios: [(net working capital)/ (total assets), (retained earnings)/ (total assets), (earnings before interest and taxes)/ (total assets), (market value of equity)/ (book value of liabilities), (sales)/ (total assets) to determine the likelihood of bankruptcy amongst companies (Auchterlonie, 1997).

Zones of Discrimination and Formula Equation of Z-score Altman Model:

* Z-Score more than 3 (Z>3)--Healthy zone

* Z-Scores in between 1.8 and 3 (1.8< Z<3)--Grey zone

* Z-score below 1.81 (<1.81) - Bankruptcy zone or high probability of bankruptcy The Altman Z-score was calculated using the following equation:

Z = 1.2 [X.sub.1] + 1.4 [X.sub.2] + 3.3 [X.sub.3] + 0.6 [X.sub.4] + 1.0 [X.sub.5]

Where:

Z = Overall index of corporate health

[X.sub.1] = Net working capital/{----------}Total Assets

[X.sub.2] = Retained earnings{{----------}/Total Assets

[X.sub.3] = Earnings before interest and tax{----------}/Total Assets

[X.sub.4] = Market value of Equity{----------}/Book value of Liabilities

[X.sub.5] = Sales{----------}/Total Assets

It should be noted here that weighting of various ratios is different for this model. Eidleman (1995) defines each of the above ratios as follows:

[X.sub.1]: is a liquidity ratio. The purpose is to gauge the liquidity of the assets "in relation to the firm's size".

[X.sub.2]: is an indicator of the "cumulative profitability" of the firm eventually.

[X.sub.3]: is a measure of the firm's productivity, which is essential for the long-term continued existence of a company.

[X.sub.4]: defines how the market views the company. The assumption is that with information being transmitted to the market on a regular basis, the market is able to determine the worth of the company. This is then compared to the firm's debts.

[X.sub.5]: describes this as a "measure of management's ability to compete". However, Eidleman cautions that the ratio varies crossways the industry.

Analysis and Discussion

The researchers used Z-score Altman model, which may indicate the financial viability of HAFED. The economic cost of business failure is relatively large. Evidence shows that the market value of the distressed firms declines substantially so it is wise to indicate about business failure in advance with the help of bankruptcy prediction models. Further ratio analysis also has been done to understand and evaluate the results of the firm operation.

Z-score Altman Model Results

Table I is a brief summary of financial statements analysis of the firm for the period (2004-2005 to 2008-09) using Altman equation. Table I shows that 3.04 are the lowest z-score (2006-2007) and 4.02 are the highest z-score (2007-2008). Z-score of HAFED remains more than 3 throughout the study period, which is indicating towards healthy financial position of the federation. Hence, it is the matter of pleasure for the suppliers of the capital, investors and creditors, management and employees stakeholders as well as for farmers that HAFED stands in the healthy zone in terms of its financial viability, in other words there is no chance of bankruptcy in near future. In the year 2004-2005 z-score was 3.948 following 3.78 in the year 2005-2006. There was a further decrease up to 3.04 in the year 2006-2007 but afterward it was increased and reached up to 4.02 in the year 2007-2008. In the last year of the study it was again decreased and touched 3.367 z-score.

Basic Financial Ratios: To support the Altman model ratio analysis also have been done. The readers cannot easily reply questions about a firm's profitability and risk from the raw information in financial statements. However, financial ratios analyses permit the analyst (1) to evaluate the past performance and current financial position of a firm and (2) to project its probable future performance and condition. Four important types of ratios are:

A. Liquidity ratios: measures the firm's ability to meet its maturing short-term obligations.

B. Leverage ratios: measures the extent to which the firm has been financed by debts. Creditors look to the equity to provide a margin of safety, but by rising funds through debt, owners add the benefit of maintaining control of the firm with a restricted investment.

C. Activity ratios: measures how efficiently a firm is using its resources.

D. Profitability ratios: measures management's overall effectiveness as shown by the returns generated on sales and investment.

Ratios alone may signify little. No doubt ratios vary according to the trading conditions. It is only when they are related to composite ratios of the industry, or ratios of the same firm compared over a number of time periods, than they acquire more significance. Trend analysis involves computing the ratios mentioned above for the given period to review whether the firm is improving or deteriorating. Table (II) represents the firm comparative analysis for the key ratios of the federation.

a) Liquidity Ratios Results

Table II portrays that short term financial position of the firm is improving time to time with some exceptions, but yet it is not satisfactory. In this direction current ratio has been increased from 37.19 percent (2004-05) to 110.07 percent (2008-09). Similarly, quick ratio reached up to 82.3 percent (2008-09) starting from 9.62 percent (2004-05) except some fluctuations. Therefore the firm may able to meet its short term debts. It may be noted that the bankruptcy analysts and mortgage originators frequently use the liquidity ratios to determine whether an organization will be able to continue as a going concern.

b) Leverage Ratios Results

During the given period, the burden of the firm's debt slightly decreased as a ratio of Debt/Equity from 5.54 percent to 5.12 percent. Decrease in debt equity ratio during the study period showing that the federation has been conservative in financing its growth with debt. The debt-to-capital ratio gives an idea to users of an organizations financial structure along with some insight into its financial strength. Decreasing debt-to-capital ratio from 1.68 percent to 0.513 percent indicates towards falling debt than its equity, showing the strengthening of financial position of HAFED. The owner's contribution almost remains same; it varies only from 43.28 percent to 43.23 percent for the given period, which may be treated an indication to stagnant capital structure. Further, fixed assets might also have been acquired from proprietary fund, which is showing 47 percent proprietary funds for the study period. The number of times interest covered by current earnings has increased from 113 times to 186 times, which may able to satisfy the expectations in terms of interest payment of money lenders.

c) Turnover Ratios Results

Inventory turnover, which measures the efficiency of inventory utilization, has decreased from 8.71 to 4.3 times. A low inventory turnover may reflect dull business, over investment in inventory, accumulation of stock at the end of the period in anticipation of higher prices or of greater sales volume, incorrect inventory resulting from the inclusion of obsolete and unsalable items, and excessive quantities of certain inventory items in relation to immediate requirements. Trend analysis demonstrates the increasing period of inventory turnover from 42 days to 85 days. Decreasing inventory turnover indicates towards poor sales, excess inventory and therefore wastage of valuable resources. But, there is drastic improvement in debtors' turnover ratio increased from 2.78 times to 89.4 times; it reflects that the collection policies of HAFED are under continuous watch. Similarly, improvement in creditors' turnovers ratio from 56.09 times to 156 times reflected that the creditors are being paid promptly during the analysis period. This situation enhances the credit worthiness of the HAFED. However, a very favorable ratio to this effect also shows that the business is not taking full advantage of credit facilities allowed by the creditors. There are minor changes in Working capital turnover ratio and assets turnover ratio. Both ratios should be improved for modifying the results.

d) Profitability Ratios Results

Analyses of this group of ratios are not encouraging. The gross profit to the total sales is lying in between 3.89 percent to 7.93 percent. Further, there is insufficient improvement in net profit ratio, which is improved 0.66 percent to 10.4 percent for the given period. The firm should take care of official expenses, because there is surprising increment in office expenses/ total assets, which is increased from 13.14 percent to 149.6 percent.

Limitations of the Study

The z-score Altman is based on the bankruptcy studies done by Altman. Those studies were performed during the years 1946-1965. It is not clear that past experience will always be transferable to future situations given the dynamic environment in which business operates. Probably no, so that this model may need to be adjusted specially the weights assigned to each ratio. Then model may able to truly reflect today's financial conditions. Further, we have calculated only 16 ratios but numerous types of ratios are available in practice.

Conclusion

The present study reveals that Z-score of HAFED remains more than 3 (healthy zone) throughout the study period with minor fluctuations, which is indicating towards healthy financial position of the federation. Different ratios indicate that the firm is being improving its short term and long term financial position year after year with some exceptions. Liquidity ratios of HAFED reflect that short term financial position is improving, but yet it is not satisfactory. Leverage ratios indicate towards sound long term financial position of HAFED. Similarly, rapidly increasing debtors' turnover ratio puts the firm in healthy economic circumstances. On the same pattern increasing creditors' turnover ratio may add to the creditworthiness of the federation. But, decreasing inventory turnover indicates towards poor sales, excess inventory and therefore wastage of valuable resources. In the starting year of the study profitability ratios annoyed the stakeholders later it is improved and trying to make happy the related parties. Based upon our financial analysis, we may conclude that the HAFED may on a going concern in the future. Therefore, we believed that the predictive results are important and will be a helpful management tool to foresee short term outcomes for the federation and how to achieve financial efficiency.

Recommendations

Following steps to be taken to strengthen the HAFED improve its financial position and perhaps avoid the bankruptcy in future:

1) HAFED should review pricing policies because sales figures are not performing well.

2) HAFED can raise debt fund for further capital requirements and can use the "trading on equity" concept of management. Because HAFED profitability showing less returns for investors, further federation's capital structure is not going balanced one.

3) HAFED has large amount of reserves and surpluses, so it may be suggested that excess funds should be invested in high return/yield securities.

4) Manage the inventory on a productive capacity (e.g. control raw materials movement by using a just-intime inventory system). Also control the movement of stock; the quicker the goods move, the better for company.

References

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Jitender Kumar

Assistant Professor, Department of Management, Studies and Humanities, Deenbandhu Chhotu Ram University of Science and Technology, Murthal.

Karam Pal

Associate Professor, Haryana School of Business, Guru Jambheshwar University of Science and Technology, Hisar.

S.N. Mahapatra

Associate Professor, Department of Management Studies, Deenbandhu Chhotu Ram University of Science and Technology, Murthal.

Surender Singh Kundu

Assistant Professor, Department of Commerce, Choudhary Devi Lal University, Sirsa. Table I Result Analysis by Using Altman Equation for the Period (2005-2009) 2004-05 2005-06 1623325026/ 2275334172/ [X.sub.1] = Net Working Capital/ 10352421711 12529044630 Total Assets 15.68 % 18.16% [left arrow] [X.sub.1] 3838870015/ 3801223302/ [X.sub.2] = Retained Earning/ 10352421711 12529044630 Total Assets 37.08% 30.34% [left arrow] [X.sub.2] 656505425/ 1198687838/ [X.sub.3] = Net profit/ 10352421711 12529044630 Total Assets 6.34% 9.57% [left arrow] [X.sub.3] 4480903711/ 4642223503/ [X.sub.4] = Market value of equity/ 5871514999 7886821127 Total Liability 76.316% 58.86% [left arrow] [X.sub.4] 26622717579/ 30950943347/ [X.sub.4] = Sales/ 5871514999 12529044630 Total Assets 257.164% 247.03% [left arrow] [X.sub.5] 0.012*15.68% 0.012*18.16% 0.012*X1 = 0.188% = 0.22% 0.014*37.08% 0.014*30.33% 0.014*X2 = 0.52% = 0.42% 0.033*6.34% 0.033*9.57% 0.033*X3 = 0.21% = 0.32% 0.006*76.315% 0.006*58.86% 0.006*X4 = 0.46% = 0.35% 0.010*257.164% 0.010*247.03% 0.010*X5 = 2.57% = 2.47% 3.948% 3.78% [left arrow] Total Z-Score 2006-07 2007-08 3246609042/ 3437507940/ [X.sub.1] = Net Working Capital/ 15556733606 19976306142 Total Assets 20.86% 17.21% [left arrow] [X.sub.1] 3855243108/ 3975020396/ [X.sub.2] = Retained Earning/ 15556733606 19976306142 Total Assets 24.78% 19.89% [left arrow] [X.sub.2] 1381620166/ 981585317/ [X.sub.3] = Net profit/ 15556733606 19976306142 Total Assets 8.88% 4.91% [left arrow] [X.sub.3] 5468175875/ 6008716912/ [X.sub.4] = Market value of equity/ 10088557720 1396758923 Total Liability 54.20% 430.19% [left arrow] [X.sub.4] 28383432919/ 26275707608/ [X.sub.4] = Sales/ 15556733606 33471575442 Total Assets 182.45% 78.50% [left arrow] [X.sub.5] 0.012*20.86% 0.012*17.20% 0.012*X1 0.25% 0.21% 0.014*24.78% 0.014*19.89% 0.014*X2 = 0.35% = 0.28% 0.033*8.88% 0.033*4.91% 0.033*X3 = 0.29% = 0.16% 0.006*54.20% 0.006*430.18% 0.006*X4 = 0.33% = 2.58% 0.010*182.45% 0.010*78.50% 0.010*X5 = 1.82% = 0.79% 3.04% 4.02% [left arrow] Total Z-Score 2008-09 2701993580/ [X.sub.1] = Net Working Capital/ 33471575442 Total Assets 8.072% [left arrow] [X.sub.1] 3975020396/ [X.sub.2] = Retained Earning/ 19976306142 Total Assets 19.89% [left arrow] [X.sub.2] 2028807822/ [X.sub.3] = Net profit/ 3347157442 Total Assets 60.61% [left arrow] [X.sub.3] 6237726482/ [X.sub.4] = Market value of equity/ 27233848962 Total Liability 22.90% [left arrow] [X.sub.4] 28383432920/ [X.sub.4] = Sales/ 33471575442 Total Assets 84.80% [left arrow] [X.sub.5] 0.012*8.072% 0.012*X1 0.097% 0.014*19.89% 0.014*X2 = 0.28% 0.033*60.61% 0.033*X3 = 2.0% 0.006*22.90% 0.006*X4 = 0.14% 0.010*84.79% 0.010*X5 = 0.85% 3.367% [left arrow] Total Z-Score Source: Researchers calculations Table II Basic Ratios Of Hafed For The Period (2004-05 To 2008-09) 2004-05 2005-06 2006-07 Ratio a) Liquidity Ratios 37.19% 135.38% 134.97% Current ratio 9.62% 52.7% 88.7% Quick ratio b) Leverage Ratios 5.54% 5.90% 3.21% Debt equity ratio 1.68% 2.08% 0.894% Debt-to-capital ratio 43.28% 37.05% 30.28% Proprietary ratio 46.4% 44.01% 39.49% Fixed assets to proprietary fund ratio 113 times 128 times 132 times Interest coverage ratio c) Turnover Ratios 8.71 times 2.7 times 2.9 times Stock turnover ratio 2.78 times 79.35 times 56.4 times Debtors turnover ratio 16.40 times 13.60 times 8.792 times WC turnover ratio 12.30 times 13.4 times 15.90 times Assets turnover ratio 56.09 times 130.03 times 148.7 times Creditors Turnover ratio d) Profitability Ratios 3.89% 4.69% 4.82% Gross profit ratio 0.66% 1.88% 2.66% Net profit ratio 97.8% 96.81% 100.94% Operating profit ratio 13.14% 12.45% 115.26% Office exp. ratio 2007-08 2008-09 Ratio a) Liquidity Ratios 12.40% 110.07% Current ratio 76.3% 82.3% Quick ratio b) Leverage Ratios 4.38% 5.12% Debt equity ratio 1.11% 0.513% Debt-to-capital ratio 40.81% 43.23% Proprietary ratio 43.41% 47.37% Fixed assets to proprietary fund ratio 162 times 186 times Interest coverage ratio c) Turnover Ratios 3.1 times 4.3 times Stock turnover ratio 76.2 times 89.4 times Debtors turnover ratio 7.64 times 10.50 times WC turnover ratio 11.8 times 15.4 times Assets turnover ratio 122 times 156 times Creditors Turnover ratio d) Profitability Ratios 4.14% 7.93% Gross profit ratio 2.23% 10.4% Net profit ratio 108.2% 156.42% Operating profit ratio 166.44% 149.6% Office exp. ratio Ratio Formula Ratio a) Liquidity Ratios Current assets/current liability Current ratio Liquid asset/current liability Quick ratio b) Leverage Ratios Debt/equity Debt equity ratio Debt/Shareholder's equity + Debt-to-capital ratio debt Equity/total assets Proprietary ratio Fixed assets/net worth Fixed assets to proprietary fund ratio EBIT/fixed interest charges Interest coverage ratio c) Turnover Ratios Cost of goods sold/average Stock turnover ratio stock Net annual credit sale/avg. Debtors turnover ratio Debtor + avg. BR Cost of goods sold/WC WC turnover ratio Cost of goods sold/total assets Assets turnover ratio Net annual Cr. Purchase/ Creditors Turnover avg. Creditors ratio d) Profitability Ratios GP/net sales*100 Gross profit ratio Net profit/net sales*100 Net profit ratio Cost of goods sold + operating Operating profit ratio exp./net sales Office exp./Total Assets Office exp. ratio Source: Researchers calculations