Companies uses bankruptcy models as there are many stakeholders involved in the business like shareholders, employees, suppliers, government, customers, lenders, general public and companies has to take care of the interest of their shareholders in order to survive in the market. The main reason of the business failure is high interest rate and long term debt.(Rees, 1995). Suppliers, creditors and banks are getting effected and if the auditors did not inform before time through the issuance of qualified audit opinion then they are in the threat of facing lawsuit. Since Beaver (1966) it's been reduced despite multiple discriminate analysis is used but some questions were raised imposed by models on restrictive statistical requirement. In 2001 Enron failed and in 2002 another 25 firms bankrupt with the liabilities of more than $ 1Billion. In UK almost 12000 companies filed for bankruptcy alone in 2007 and this number will increase to 13500 (Financial Times 02 Jan 08). Altman Z score is considered a pioneer model after Beaver.Ratio analysis is very useful in order to find out the problems in the operation of a company but it does not work in doing comparison of two or more companies due to their different policies (Neophytou, E et al, 2004). Altman's Z score and Argenti's A score have proved to be helpful in predicting the company's failure with the help of research.
Corporate failure models are divided in two groups, Quantitative and Qualitative models. Quantitative models are largely based on financial information which is published and qualitative models are based on internal assessment of a company. Quantitative models help us in identifying financial ratios that separate surviving and failing companies and it also look on financial indicators that are low profitability to assets, low equity returns, poor maintenance of leverage and ratio of debt/equity and uncertain variability of income.The Z score was developed by Altman in 1968.The model considered 22 ratios which are based on their popularity. Out of 22 only 5 ratios are used on the basis that do the best job for predicting bankruptcy. Z score also assigns weights to the ratios which are important and then combine all ratios in a single measure by using multiple discriminate analyses. It also helps in deriving a linear combination of ratios to define between bankrupt and non bankrupt companies. The final model is Z= (1.2 x X1)+(1.4 x X2)+(3.3 x X3)+(0.6 x X4)+(1.0 x X5) X1 = Working Capital/Total Assets: Working capital is defined as current assets minus liabilities and it is the measure of net liquid assets of the firm relative to the total capitalization. X2 = Retained Earnings/Total Assets: Retained earnings is the total amount of reinvested earning's and losses of a firm throughout its life. It also measures the leverage of the company. New companies have higher profitability of having bankruptcy as they won't have had time to build retained earnings. X3 = Earnings before Interest and Tax (EBIT)/Total Assets: Measures the productivity of the firm assets which is independent from tax and leverage factors. X4 = Market Value of Equity/Book Value of Total Debt: It shows how far firms' assets can decline in value before liabilities exceed assets. This ratio also tells us about the assets that decline before the firm become bankrupt. X5 = Sales/Total Assets: This ratio shows how a company maintain its profit and it is least significant ratio, however because of its relationship to other variables it ranks high in contribution. Z-Score ?bove 3.0 indicates that the comp?ny is 'S?fe'. Z-Score Between 2.7 ?nd 2.99 means that the company should be on alert.If the Z-Score is Between 1.8 ?nd 2.7 it means that there is a good ch?nce of the comp?ny going b?nkrupt within 2 ye?rs of oper?tions. Z-Score Below 1.80 is classified as potential failure
In essence the Z score is the summary statistic of the issues/risks of liquidity, operational and leverage problem. However Z score examines extensively as a Dupont analysis and is used in one or more form to access credit risk/bankruptcy. It is easy to understand and to apply as we only need balance sheet, income statement, stock/ share price and a calculator or we can do on computer and it is less costly as well (Altman 1993). Z score is based on the model built on empirical evidence and it is useful for number of users including loan officers, internal management and investment portfolio manager or individual investor because they can easily identify the undesirable risk. It also provided a break point that helps the decision maker in explaining his opinion about the bankruptcy of a company (Elliot & Elliot, 2006). Further studies have identified and attempted to correct perceived weaknesses in Altman's model. It does not have any time scale and it is only reliable if the firm is less than three years away from failure (Blum, 1974). There are two kinds of financial ratios normative and positive, in spite of success in both kinds of ratios yet there are some problems which are a) the choice of firm and ratio for comparison with each other b) the means of combining the ratios into a single measure of performance and choice of benchmark. It uses historical data to predict company failure which may be different from the present scenario (economic condition) so we cannot rely on it (Pike and Neale, 2003). The basic purpose of ratios is to control the size of the firm and to control the proportion between numerator and denominator but it can easily be violated so we cannot fully rely on it. It also introduces redundancies in the analysis if the number of ratios increases and it makes the interpretation of result difficult. After facing criticism (Altman et al, 1977) developed a new model with 7 variables. Its classification accuracy was more accurate with 70% accuracy up to 5 years before failure and had slightly better accuracy for prior one and two years. Argenti A score is a qualitative model and it was developed by Argenti (1983). In this model numbers are assigned to the variables of the company and financial measures are being used sole measures. The model comprises of three parts a) defects b) mistakes c) symptoms and all these paths follow a different approach of progress . In A score, different scores are assigned to each defect, mistake and symptoms on the basis of their importance and these scores were being compared with the benchmark which has been founded before the model. If a score of a company is between 0 to 18 then it considered good but if the total score is more than 25 with a defect score of more than 10 and mistake score is more than 15 then it means company is going towards bankruptcy. (Elliot & Elliot, 2006). All the numbers are added after assigning the score and see if the company is going towards bankruptcy. It helps to find the cause of failure and try to figure out why and how it happened. It does not use historical data like Z score. The model is very subjective and it does not depend on the financial information of the company and includes mixing of indicators. The reason why the information in financial statements is always not useful is because sometimes there is a chance of creative accounting so we cannot rely on it. It also checks the non-financial signs of the company failure (Elliot & Elliot, 2006). The main disadvantage is that it is subjective, unscientific model and there is no set of rules in mixing of indicators and the weighting assigned to indicators (Regan, 2006). According to (Mearns, 1991) the model is too generalized and when it was applied to Lesney a "Match Box" producer which went into liquidation. The study rejects the defect and symptom scores with regards to Lesney as company was failing and this is also in case of Laker Airways (Robertson's 1984). It shows that there is no set rule for mixing of indicators. This indicates that the part of the A Score model with the most credibility could be the Mistakes section, where the items have given biggest weightings.
In conclusion the Z score rely on financial statements to predict what will going to happen in future as it will check the working capital, liabilities, retained earnings, earning before tax, market value of the company and if the future of the company is in secure hands it will be beneficial for the stakeholders. With Z score we can find the problem if the company is not going well but it cannot help us in finding the cause of the problem so we apply A score on that company to find the cause of the problem that in which section it got problem. Despite of shortcomings both Z score and A score are useful tool as long as decision makers user their judgement, particularly for the reliability of the information contained in financial statement.