Bankruptcy Prediction in the WorldCom Age

For decades, considerable accounting and finance research was directed at creating a model for predicting bankruptcy. Early attempts to discover a single best accountingbased predictor eventually gave way to more comprehensive models involving both accountingand market-based indicators. This paper reviews one of the most popular of those bankruptcy prediction models, the Z-score model developed by Edward Altman in 1968. Also included is a brief discussion of later developments in credit analysis. BANKRUPTCY PREDICTION IN THE WORLDCOM AGE 2 Introduction According to Pate (2002), 257 public companies, with total assets of $256 billi on, filed for bankruptcy in 2001. That this is the highest number of bankruptcy fili ngs since 1980 is alarming. Furthermore, it is uncomfortably large compared to the number of fili ngs during the last recession (125 fili ngs in 1991 and 91 fili ngs in 1992). Pate further estimates the likely number of public company bankruptcy fili ngs in 2002 will be about 200, 22 percent below the 2001 level, but still well above the 1986-2000 average of 113. Another clearly visible trend is the increase in the number of large companies going bankrupt. Altman (2000) points out that bankruptcy in firms with large asset size, while quite rare prior to 1966, became more common in 1970s. According to Altman, since the enactment of the current U.S. Bankruptcy Code in 1978, there were at least 100 Chapter 11 bankruptcies of f irms whose asset size exceeded $1 billi on. In this environment, business leaders and finance professionals would be well advised to refresh their knowledge of bankruptcy prediction models. Fortunately, those models have been around for a while. The present paper is intended to serve as an introduction into one of the most popular bankruptcy prediction models, the Z-score model developed by Edward Altman in his pioneering 1968 paper. The Z-score Model For decades, considerable accounting and finance research was directed at finding a ratio that would serve well as a predictor of bankruptcy. One of the most comprehensive studies of that early era was Beaver (1967). Beaver studied the BANKRUPTCY PREDICTION IN THE WORLDCOM AGE 3 performance of various ratios as bankruptcy predictors and concluded that the cash flow to debt ratio was the single best predictor. The criti cal breakthrough in bankruptcy prediction came with Altman (1968). Altman decided to abandon the search for a single best ratio and built a comprehensive, statistical model using a technique called multiple discriminant analysis (MDA). MDA allows a researcher to group observations into several pre-determined categories based on several characteristics of an observation. Altman selected a sample of 33 manufacturing companies that filed for bankruptcy in 1946-65 and matched them with another 33 companies selected on a stratified (by both industry and asset size) random basis. Altman then started with 22 ratios that seemed to be intuitively plausible as bankruptcy predictors. After every run, he excluded the ratio that contributed least to the explanatory power of the model. Eventually, he came up with a model that contained only five ratios. The original Altman model took the following form: Z = 0.012 X1 + 0.014 X2 + 0.033 X3 + 0.006 X4 + 0.999 X5 (1)