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The Assessment of Company Solvency and

Performance Using a Statistical Model
R. J. Taffler
Published online: 28 Feb 2012.

To cite this article: R. J. Taffler (1983) The Assessment of Company Solvency and Performance Using a
Statistical Model, Accounting and Business Research, 13:52, 295-308, DOI: 10.1080/00014788.1983.9729767

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 AUTUMN 1983
The Assessment of Company Solvency and
Performance Using a Statistical Model
R. J. Taffler
Introduction
Much of the current dissatisfaction with the infor-
mational content of published financial statements
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can be traced to the incorrect manner in which they
are conventionally used. Concentration on individ-
ual accounting numbers or ratios obscures the true
value of the published accounts: that they measure
a number of distinct and fundamental aspects of a
company simultaneously, i.e. they are multivariate
documents. Thus, for example, to evaluate an
enterprise’s performance in terms of its
profitability alone, ignoring other characteristics
such as its financial risk, working capital and
degree of liquidity, can result only in an incomplete
and potentially misleading view. Once a number of
different facets of the firm are considered together,
and particularly when these are viewed relative to
other firms rather than on an absolute basis, then a
company’s published statements become extremely
valuable documents for many basic decision pur-
poses and different types of user.
This paper illustrates the benefits that accrue
when published accounting information is used
correctly in an holistic and relative manner. It
describes a UK-based linear discriminant model,
which has been in operational use for some years,
requiring a number of different accounting inputs
derived from conventional financial statements for
the determination of a fundamental decision, uiz-
the evaluation of an enterprise’s financial viability.
The track record since the model’s development is
discussed, and the degree of true predictive ability
is assessed. Two related developments to the
approach are also described and evaluated here.
The first, the risk index, appears to provide an
accurate measure of the actual degree of risk of
financial distress faced by a company. The second,
a transformation of the z-score, provides a single
readily interpretable measure of relative company
performance, permitting valid cross-sectional and
inter-temporal performance comparison.
In the first section of this paper, the approach
adopted in developing the original solvency model
295
is briefly described and, in the second, the derived
model is outlined. Section 111 provides various tests
of its effectiveness, its true ex ante predictive ability
and its track record since it was developed. The
risk index is also described. The next section
discusses why the derived model appears to work
so well within its frame of reference. This is
followed in section V by a description of the
PAS-score transform. The paper is concluded with
a summary and some thoughts on the value of such
models to the financial statement user.
I The methodological approach
The application of multivariate statistical tech-
niques to problems in accounting and business
finance constitutes a relatively new but very
significant advance in available methodology. In
1968, E. I. Altman published the seminal paper:
‘Financial Ratios, Discriminant Analysis and the
Prediction of Corporate Bankruptcy’. In this he
described a discriminant analysis approach to the
problem of corporate bankruptcy prediction and
clearly demonstrated the value of considering
financial ratio data within a multivariate decision
model framework. Since Altman’s original work, a
voluminous literature has evolved using a related
approach to identify potential insolvent concerns
in such diverse industries as railroads (Altman,
1973), banks (Sinkey, 1979), insurance companies
(Trieschmann and Pinches, 1973), over-the-
counter broker dealers (Altman and Loris, 1976)
and savings and home loan associations (Altman,
1977) etc.] Such techniques have also been widely
used for many years in the USA by banks, govern-
ment regulatory agencies, stockbrokers, auditors
and the like as the sine qua non of an efficient
monitoring process. However, interest in the ap-
proach has been slow to develop outside the USA,
‘A fuller list of references is provided in Taffler (1982), which
also provides a critique of the extant US-based studies and
h c f i b e s the statistical methodology and points arising in
detail.
 296
although by now there have been a number of
related studies in other environments. For example
Altman et al. (1974) developed a model using
French data, and related work has. also been
undertaken in The Netherlands by van
Frederikslust (1978), in Australia by Castagna and
Matolcsy (1981) and in Brazil by Altman et al.
(1 979), who also provide other references to work
outside the USA.
Here in the UK an early model completed in the
summer of 1974 and used for many years sub-
sequently by a firm of London stockbrokers to
provide a service to their clients is described in
Tamer (1982). Two more recent UK studies are
those of Mason and Harris (1979) for the analysis
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of construction companies and Marais (1979)
which describes preliminary work undertaken for
the Bank of England. DataSTREAM Inter-
national PLC, a widely used UK commercial on-
line computerised company financial information
service has been offering its subscribers a z-score
model since the middle of 1980 which is advertised
as ‘. . .the most effective screening tool yet devised
for the purposes of credit analysis/corporate
finance.’*
The model to be described below was developed
at the beginning of 1977 explicitly for the analysis
of UK quoted manufacturing and construction
enterprise^.^ It requires as input four appropriately
defined financial ratios each measuring a distinct
aspect of a company’s performance. Its application
results in a computed z-score which can be inter-
preted as indicating the degree to which the
financial profile of the concern under examination
’However, despite the hyperbole, the ‘technical review’
(dataSTREAM, 1980) demonstrates a number of serious
methodological problems in the construction of this model.
These would go some way towards explaining why, in practice,
the dataSTREAM model is only effectively measuring the
profitability of an enterprise, with the balance sheet largely
ignored. In fact, an investigation of a large sample of
companies indicates that the model’s profitability ratio (profit
+
before tax depreciation/current liabilities) is correlated at
0.986 with its calculated z-score and, as such, can be used as
a direct proxy. Thus a decision rule that classified a company
with a ratio value below 0.20 as ‘failing’ and vice versa would
apparently provide the same classification as the data-
STREAM model 95% of the time.
‘Because of the very different financial structures of indus-
trial and distribution companies in the UK. separate models
are needed. A related model for the analysis of retail and
wholesale concerns has also been developed by this author.
However, since the methodology used and results obtained are
similar to those described here, discussion of this model will
not be pursued. Experiments applying each model to the data
set of the other suggest the need for distinct models. They also
suggest that it is likely that the pooling of disparate enterprises
in the construction of such a solvency model will reduce its
effectiveness in subsequent application.
ACCOUNTING A N D BUSINESS RESEARCH
resembles more that of previous failures, which is
a necessary but not sufficient condition for financial
distress, or that of typical financially healthy com-
panies. This latter is effectively both a necessary
and sufficient condition for continuity, at least until
publication of a later set of accounts. An analysis
of the results from application of the model since
it was developed is provided in section 111.
Discriminant Analysis
The discriminant technique is well described in
the literature and need not detain us here.4 Essen-
tially it aims at distinguishing between two or
more distinct populations on the basis of certain
of the characteristics of their members and the
classification of further individuals as belonging to
one of the populations more than to any of the
others. In our case the two group situation is
appropriate, with failed and solvent firms consti-
tuting the data samples from which the discrimi-
nant model is derived, and with the variables
consisting of financial ratios derived from con-
ventional profit and loss accounts and balance
sheets.
If certain statistical assumptions apply,5 then a
linear function of the form
z = co + c l r l+ c2r2+ .. . c,,r,,
is appropriate where co. . . c, are the discriminant
coefficients and Y, . . . r,, the constituent ratios.
The Data
The failed group of concerns, 46 in number,
consisted of all those quoted on the London Stock
Exchange and predominantly engaged in manu-
facturing activity which were identified as going
bankrupt6 between the beginning of 1969 and the
end of 1976, a period of eight years, and which also
~ ~ ~~ ~. ~
4See, for example, Eisenbeis and Avery (1972). Lachenbruch
(1975) or Green (1978). Detailed reviews of the problems likely
to be experienced in the application of multiple discriminant
analysis in business applications are provided by Eisenbeis
(1977) and Pinches (1980).
5These are, specifically, that the two samples are each
representative of their underlying populations, are separately
distributed multivariate normal and have common dispersion
matrices. If, however, dispersion matrices are unequal, then
theory suggests a more complex quadratic formulation. How-
ever, as discussed in Taffler (1982), departures from multi-
variate normality and small sample sizes, which are typical in
financial applications, render application of a quadratic model
inappropriate, despite the presence of unequal dispersion
matrices. This, again. is almost inevitable in such applications.
As a result the quadratic model will not be considered further
here.
‘Although, strictly speaking, the term bankruptcy relates
only to actions against individuals and partnerships under the
1914 Bankruptcy Act, it is used here in accordance with
American parlance to refer to corporate failure.
 AUTUMN 1983
met various criteria to ensure reliable source data.'
Half the companies failed in 1975 or 1976. The
average time between publication of last accounts
and date of failure was just under 8 months.
Bankruptcy status for our purposes was indicated
by the appointment of a receiver, entry into cred-
itors' voluntary liquidation, winding up by Order
of the Court or clear action on the part of the
government.8 One company was also included be-
cause a substantial equity injection was provided
to it by the City in 1975 to avoid threatened
government intervention of a similar nature.'
Virtually all related studies appear to view non-
failed (i.e. continuing) concerns as being distinct
from bankrupt enterprises. However, it was recog-
nised here that a proportion of presently con-
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tinuing companies possess financial profiles more
similar to those of previous bankrupts, and many
of these will in fact subsequently fail. Thus, sam-
pling at random from presently continuing con-
cerns is likely to result in less distinct samples and
consequently a less powerful model.'" To overcome
such problems to some degree, a two stage sam-
pling process was adopted to obtain solvent firms.
Initially 46 companies were drawn from the Jordan
Dataquest data-base, randomly matched by size
and industry with the failed sample. A subjective
screening process using conventional techniques of
financial analysis was then applied to the accounts
of these companies, and 5 were considered very
unhealthy. These were replaced with randomly
selected enterprises, none of which was judged to
be problematical." Where necessary, for both the
failed and solvent firms, adjustments to the data
'Only a handful of concerns however had to be rejected.
Failing companies engaged in construction and related activ-
ities, numbering about 10, were excluded because of potential
differences in the structure of their accounts compared to those
of manufacturing concerns. However. subsequent application
of the resulting solvency function to contracting and construc-
tion companies indicated such worries were unfounded.
'As in the cases of British Leyland, Alfred Herbert and
Ferranti.
'This company, Fodens, after a further large injection of
long term funds by its bankers, ultimately failed in 1980,
illustrating the maxim that the provision of funds alone can
only postpone the arrival of the bailiffs.
'"These issues are discussed further in Taffler (1982).
"Lachenbruch (1974) provides statistical justification for
this attempt to work with distinct samples. He demonstrates
that, when sample observations are initially incorrectly
classified to discriminant groups in a non-random fashion, there
are serious problems in interpreting the classification matrix
obtained by applying the model to the original data. Such
difficulties, inter alia, may go some way towards explaining the
size of the type I1 errors-classification of a non-failed as
failed-in the original sample of Marais (1 979) and particularly
with his hold-out data.
297
,ere made for such things as revaluation and
company growth through acquisition, to improve
compatibility and consistency.
The Variables
The lack of any real theory relating to the use of
financial ratio analysis constitutes a serious gap in
the accounting literature.12 By reference to what
literature there is in the area and a comparison of
measures found useful in related or in some sense
similar studies, 80 potentially useful ratios were
identified and computed for each of the 92 con-
c e r n ~ .Each
' ~ of these ratios underwent logarithmic
or reciprocal transformations as appropriate to
improve normality and any outlying observations
were winsorised, i.e. replaced by limiting value^.'^
To understand the data better, to avoid multi-
collinearity, and to aid formulation and inter-
pretation of the resulting model, varimax rotated
principal component analysis (PCA) was under-
t a k e r ~ .In
' ~ this way the intercorrelations within the
80 variable set could be handled readily and the
underlying dimensionality of the published ac-
counting information could be identified. The re-
sults, provided in Taffler (1981), are very similar to
those of the much more representative study of
Taffler and Sudarsanam (1980) who undertook a
related analysis using a slightly augmented ratio set
and a large sample of 525 continuing UK quoted
companies for a later period. Reification of the
components identified by examining the ratios,
highly loaded on (correlated with) the same factor
and thus describing similar aspects of a company's
financial structure, indicated the company ac-
counts examined to be measuring profitability,
financial risk, working capital position, liquidity,
asset turnover, value added contribution, and cred-
itors' position. 91.6% of the variance in the data set
was accounted for by these seven factors. Similar
dimensions are also identified by Pinches et al.
-. -~ ____ . ~ _ _ _ _ ~ _
''This has. however, been partially corrected by the recent
articles of Lev and Sunder (1979) and Whittington (1980).
"Because of arguments in the literature attesting to the
utility of funds Row and trend measures in such situations as
those considered here, both types of variable were computed
in an earlier investigation (Taffler. 1982). However, no useful
contribution was made by either class and they were dropped
from further consideration at an early stage in the analysis.
As a result of this experience, no such measures were employed
in this study. The list of ratios used here is given in Taffler
(1981).
I4Univariate normality of the constituent variables is a
'necessary but not sufficient condition for multivariate
normality. Lachenbruch et 01. (1973) suggest the linear
discriminant model suffers least from non-normality when the
constituent variables are bounded.
l5See for example Green (1978).
 298 A C C O U N T I N G A N D BUSINESS RESEARCH

Table 1
What the constituent ratios are measuring
Dimension of Information Contribution
Ratio ' Represented to Model (%)*
~~

1. PBTiAVCL Profitability 53
2. CA/TL Working Capital 13
3 . CL/TA Financial Risk 18
1 4. No-Credit Interval Liquidity 16
I *Mostelk-Wallace measure. I
(1975) and Johnson (1979) in US published ac- derived, prior probability estimates of the propor-
counts.16 tions of failing and solvent concerns in the UK
quoted manufacturing population have to be in-
corporated into the function. Since, strictly speak-
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I1 The derived model ing, the approach is a descriptive not a predictive

The discriminant computer runs were then un-
dertaken to arrive at a model which was able to
discriminate effectively between the two data sets,
was parsimonious with respect to its input require-
ments, contained distinct and readily interpretable
measures and performed well in tests of its
efficiency.
A stepwise linear discriminant package
BMD07M (Dixon, 1973) was used. After many
runs the following model resulted:
+
z = co cI x profit before tax/average current
liabilities + c2 x current assets/total liabilities +
cj x current liabilities/total assets + c, x no-credit
interval
with cI. . .c4 constituting the ratio coefficients, and
co the constant." The fourth ratio, which is rela-
tively new to the literature, is measured in days,
and calculates the time for which the company
would be able to finance its continuing operations
from its immediate assets if it could no longer
generate revenue.'*
To make the model operational on other data
than the equal sized samples from which it is
'Then and Shimerda (1981) analysed in detail the 34
financial ratios found useful in a number of US bankruptcy
prediction studies and demonstrated that these could all be
assigned to seven major factors. We may note in passing the
apparent small number of distinct aspects of a company's
financial structure being conventionally reported by a set of
accounts; consequently, only a limited set of measures appro-
priately chosen, each one highly loaded on a different
component, is necessary to convey most of the information in
published statements. The importance of this for those authors
currently providing ad hoc ratio classification systems, sug-
gesting lists of ratios for company analysis purposes or
advocating the use of pyramid ratio structures, cannot be
overestimated.
"The proprietary nature of the model prevents disclosure of
the ratio weights.
"Fadel and Parkinson (1978) discuss the ratio.
one, the appropriate prior probability ratio is an
estimate of the proportion of companies with a
financial profile more similar to that of the failed
group: the proportion with a profile more similar
to that of the solvent group. An odds ratio of 1:7
was considered appropriate at the end of 1976,
resulting in a cut-off of - 1.95 on the z-scale."
A matching of the constituent ratios of the
z-model with the principal component analysis
conducted, as described in Taffler (1981), results in
the ratio interpretation of Table 1. Thus it is
possible to conclude that the derived z-model is
made up of a small number of ratios, the reasons
for the inclusion of which make intuitive sense,
that their nature is readily interpretable and that
they are each measuring a relatively distinct aspect
of the firm. In this way, then, it can be seen how
a large amount of information about a firm is
being conveyed by a small number of different
measures.
Difficulties arise in trying to assess the relative
contribution of the individual ratios to the overall
discriminant power of the z-model. There is an
extensive but conflicting literature. The approach
with most intuitive appeal" measures the propor-
tion of the Mahalanobis D2-distance between the
"The classification criterion is given by In(p,/p,) where p,
and p, represent the prior probability estimates of an insolvent
and solvent firm respectively. Here for an odds ratio of 1:7,
the criterion =In($;) = - 1.95. A more detailed discussion
including the incorporation of differential misclassification
costs, which is not appropriate in our case, is provided
amongst others by Eisenbeis and Avery (1972: 12/13), Mor-
rison (1969) and Taffler (1982). In operational usage the
constant term, co, in the z-model was adjusted to incorporate
the prior probability adjustment directly, so that a cut-off point
of zero resulted.
"A review of the arguments in the literature surrounding the
Mosteller-Wallace technique is provided in Taffler (1982). All
ratios were statistically significant at ci = 0.05 applying the
conventional conditional-deletion method.
 AUTUMN 1983
Figure 1
Z-score distribution
Failed Set
!
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-2 -16 -14 -12 -10 -8 -6
centroids of the two constituent groups accounted
for by each variable according to the following
formula:
‘J (tf- 5 7 )
pJ=
c 4ff-
4
FrJ
r=l
where pJ represents the proportion of the
D2-distance accounted for by ratio j and Frf and fr,
are the means of the failed and solvent groups for
ratio i respectively. The results are also presented
in Table 1 and indicate that the profitability ratio
accounts on this basis for around half of the total
discriminatory power of the model, with the other
three measures each contributing a similar propor-
tion of the remainder.
I11 How well does the z-model perform?
The arrangement of computed z-scores for the 92
companies from which the z-function was derived
is provided as Figure 1. The absence of any overlap
between the failed and solvent samples will be
noted. Only two concerns are apparently
misclassified by the cut-off of - 1.95: Rolls Royce
with a score of -0.04 and W & J Sagar (Holdings)
Ltd with a score of -0.56. On the basis of the prior
probability odds set, these results constitute Type
I errors (classification of a failed concern as sol-
vent) of 4.3%, and Type I1 errors (classification of
a solvent as failed) of 0%.
However, neither of the errors would appear to
299
No Solvent Set
-4 -2 2 4 6 8 10 12 14 16 +Z
be true misclassifications. In the case of Rolls
Royce, it is doubtful whether it was actually in-
solvent at the date of appointment of the receiver,
4th February 1971, since all creditors and de-
benture holders were subsequently repaid in full
and the distribution to ordinary shareholders
amounted to three and a half times the share price
when finally suspended. It can be cogently argued
that Rolls Royce entered into receivership as the
only way open to it to break its ruinous RB211
contract with Lockheed, allowing renegotiation of
the terms. Consequently, it may be argued that its
z-score was fully reflecting, at the very least, its
financial state as at 31st December 1969, the end
of the last financial year for which published
accounts were available. The other “misclassified”
concern, a small leather tanner, had not failed and
was included in the bankrupt sample in error.
Nonetheless, using a model derived from a set of
data to classify the same set leads to an upward
classification bias, due to potential sample and
search biases being present (Frank et al., 1965).
Thus other means need to be found to test its
efficiency. The best approach is, of course, to test
the function on other data than that from which it
was derived. The problems of testing for inter-
temporal validity/stability as well as for contem-
poraneous classificatory ability must also be noted.
Lachenbruch Holdout Test Results
A jack-knife test (Lachenbruch, 1967) can be
applied to the original data to produce almost
 300 A C C O U N T I N G A N D BUSINESS RESEARCH

Table 2
Industrial companies on the EXSTAT data-base with negative z-scores as at
30.11.76: summary of subsequent events over the next 4 years
Event No. of companies ”/, of companies
Financial Distress
Receivership 14 12.2
Going concern qualification’ 8 7.0
or government, bank or other
support, etc.
Acquisition or reverse 12 10.4
takeover as an apparent
alternative to bankruptcy
Major closures and disposals etc. -
6 5.2
-
40 34.8
Still ‘at risk’2 31 27.0
71 61.8
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Recoveries
Still in lowest 25% of companies’ 19 16.5
by z-score
Outside lowest z-score quartile - 25 ~
21.7
(clear recoveries) 115 100.0

Notes: 1. One company entered into receivership during 1981.

2. This category includes 3 companies acquired with at risk profiles which
could not be identified as potential insolvents. Of the remaining 28 concerns
6 experienced some form of financial distress during 1981.
3. Nine companies were at risk again during 1981 including one firm
which went into receivership.

unbiased estimates of the true misclassification True Ex Ante Predictive Ability

probabilities and also confidence intervals for the
true Type I and Type I1 errors. In this, n, n, + company financial information since early 1977’
discriminant functions are computed from the
original data samples of size n, and n, obser-
vations, with a different observation held out each
time which is then reclassified by the function
+
computed from the remaining n, n2 - 1. If m,
and m, observations respectively are misclassified
in the two groups, then the ratios m,In, and mJn,
provide the almost unbiased estimates of the true
misclassification probabilities. In Figure 2, the
Lachenbruch holdout test results are presented for
the same prior probability odds. The lack of bias
in the derived function will be observed with only
the same two concerns ‘misclassified’.’’
These results, which contrast with those in other
studies, appear to be due to the distinct nature of
the failed and solvent samples and the careful
selection of, and avoidance of collinearity in, the
discriminant model variables.
2’WhenW & J Sagar (Holdings) was omitted from the failed
sample, Rolls Royce remained the only company misclassified,
both by the resultant z-model and in the corresponding
Lachenbruch holdout test.
The availability of the EXSTAT data-base of
has allowed a true ex ante test of the predictive
ability of the z-model in practice since it was
developed. Table 2 summarises what subsequently
happened to the 115 (14%) out of 825 manu-
facturing and construction companies on file with
‘at risk’ profiles (z < - 1.95) on the basis of their
latest accounts available as at 30.11.76, when data
collection for the development of the model termi-
nated, over the following 4 years. It will be seen
that 35% had gone bankrupt or experienced events
”This comprises detailed published accounts information h
standardised computer-readable form for viitually all of
quoted industrial and distribution companies for each year
from 1972 to date, together with equivalent data for a large
number of unquoted and foreign concerns. It is compiled by
Extel Statistical Services Ltd. and updated weekly. Because of
its accuracy, ease of use and wide coverage, the EXSTAT
financial information data-base constitutes a new and very
important tool for empirical accounting and financial research
in the UK.
 AUTUMN 1983
Figure 2
Lachenbruch holdout test results
Classified as
Failed
Actual Group
Membership’
Faded
*See text for explanation of these apparent errors
that approximate economically to insolvency and
a further 27% were still at risk.23
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During 1980, a very unhappy year for British
industry, it was possible to identify clearly 30 of the
‘at risk’ major manufacturing and construction
companies on file as suffering bankruptcy or an
equivalent insolvent event.24 An average of 13%
(92) of the population of 700 live companies had
latest z-scores below - 1.95.2sAn examination of
the histories of firms that were in the lowest half
of the population by z-score at some time during
23The 10 cases of acquisition and 2 reverse takeovers of
companies with ‘at risk’ profiles in table 2 were identified from
press comment and fundamental analysis as likely alternatives
to receivership. Three other ‘at risk’ firms taken over could
not be so identified. The definition used for ‘major closures
and disposals etc.’ was reduction in employees and/or capacity,
measured by turnover, in each case by half or more. The
‘going concern qualification or government, bank or other
support etc.’ heading covered those concerns which could be
identified readily by press comment or by statements from the
companies themselves, etc. as being in receipt of emergency aid
from the government, their bankers, financial institutions or
other parties as an alternative to receivership. Because of the
avoidance of publicity by banks when involved in rescue
operations, it was likely the number of such situations
identified was actually underestimated with probably a number
of ‘still at risk’ enterprises more correctly classified under this
heading. The problem of clearly defining what constitutes
failure may be noted. An interesting comparison can be made
with the results of Deakin (1077) who, for example, also
considered default on preference dividend and ordinary divi-
dend cut or omission as failing indicators.
24Therewere 7 receiverships or equivalent, 9 going concern
qualifications, 4 explicit statements of bank support, 3 cases
of major rationalisation involving redundancies of over half
the workforce, 3 instances of emergency cash injections from
external parties and 4 of continued government support.
(Where there were multiple events the most serious is listed
here.)
25Atthe beginning of 1980, there were 69 live companies on
file ‘at risk‘ and at the end 114. As such, let us consider the
average number of live ‘at risk’ companies on file during the
year to be 92. Similarly in January 1980 there were 715 live
companies on file and 690 of these published accounts during
the year. On this basis we can consider the average number
of live companies on file during 1980 to be about 700,
301
SdVenf TofaI
1980 and that were outside the ‘at risk’ region
produced only one company that had suffered
financial distress according to the definition of
Table 2.26
On this basis, then, let us estimate that a maxi-
mum of 5% of the total population of 700 live
major quoted manufacturing and construction
companies on file experienced some form of
financial distress during 1980. In this case the
conditional probability of companies failing in the
year, given a potential failure profile
(30/92 = 0.33), and the conditional probability of
companies not failing, given a solvent profile
(effectively 1.O but say 0.99), are both significantly
different at c( = 0.001 to the null positions (5% and
95%).*’Similar results also obtain for the compara-
tive year of 1977 examined when British industry
was recovering from the 1974/75 recession.28As
26This company, Sidlaw Industries, with z-score for year
ending 30.9.79 of -0.90 closed down the major part of its
textile activities to concentrate on its highly profitable North
Sea oil service side. However, inspection indicated that
impending bankruptcy was not the cause.
27The appropriate test statistic is
P --x
z =
n(1- -x)’
l
r
where p is the sample proportion, K the probability of chance
classification (0.05), n the sample size, and z (to be dis-
tinguished from z-score) a standardised normal deviate. At risk
and ‘solvent’ (z-score > - 1.95) company samples are of size
92 and 608 whence respective z’s are found to be 12.3 and -4.8.
Pr( IzI > 3.3) < 0.001 (one tail test).
”Of the 115 out of 825 (14%) companies on file at the end
of 1976 with ‘at risk’ profiles, I5 were clearly identified as
experiencing an insolvent event during 1977. If we use this
figure to suggest that K was 2.3% (estimating the conditional
probability of an insolvent event for solvent companies apart
from receivership, which we know occurred in no instance, as
at most 0.5% (4 cases)), then the respective standardised
normal deviates are 7.7 and -3.4. Because of the amount of
work involved in replicating the analysis for 1978, 1979 and
1981, the existence of equivalent results needs to be taken on
trust, which is probably not unreasonable.
 302 A C C O U N T I N G A N D BUSINESS RESEARCH

Table 3
Average percentage of companies ‘at risk’ by year

Percentage of
Companies
Note: 80 denotes firms with accounting year ends between 1.5.80 and
30.4.81 and similarly for earlier years.

such, the derived function would appear to exhibit
true ex ante predictive ability where the events
predicted are the financial distress or otherwise of
a company within the next year.
Downloaded by [University of Glasgow] at 09:02 18 December 2014
number of sound concerns highlighted as potential
problem^.^' Thus in evaluating the operational
utility of such a function, the percentage of the
company population labelled ‘failing’ is just as

important as unbiased tests, preferably on an ex

The Percentage of Companies A t Risk ante basis, of the model’s misclassification proba-
An essential consideration in any operational bilities. Table 3 provides the percentage of major
model of the nature discussed here is that the quoted manufacturing and construction compa-
percentage of companies with potential failure nies on the EXSTAT tape that were ‘at risk’ over
symptoms that are highlighted by its application is the 8 year period to 30.4.81, which varies between
manageable by the analyst. There are theoretical 1 1% and 21% depending on the economic climate.
arguments regarding the differential costs of the
solvency function describing a subsequently failing The Risk Index or Z-Score of Z-Scores
company as solvent or vice versa.29By appropriate The z-model is of value in arriving at a list of
selection of a cut-off it is always possible to ensure potential insolvent concerns for further analysis,
that no failing company is ever missed, whatever providing the list is not too long. However, a single
the circumstances, at the expense of an unwieldy ‘at risk’ reading for a company is not very useful
for indicating the likelihood of imminent financial
distress or the possibility of recovery. Through
29Strictlyspeaking, only decisions taken can have a cost, detailed analysis of the z-score history of all those
unlike the output from an information model, which is only companies on the EXSTAT file with ‘at risk’
one input to a decision process. Altman et al. (1977) provide
empirical evidence to suggest that, in the bank loan situation profiles at any time, whether they were able to
in the US, the cost ratio of lending-to-a-defaulter to not- recover or not, three determining factors of ulti-
lending-on-a-safe-proposition is around 35: I . They use this mate financial distress were identified, uiz : mag-
ratio in setting their cut-off. However, since no banker would
ever take a decision on the basis of a bifurcated z-score alone, nitude of latest z, number of years at risk, and
this ratio does not equate to an appropriate misclassitication trend. By using a linear aggregative approach,
cost ratio for explicit incorporation into a solvency function allocating points to different values on each factor,
in the manner of Altman et al. A more valid misclassification
cost ratio would take into consideration the opportunity cost weighting and summing, a composite picture of
of the analyst’s time, as well as other factors. We implicitly underlying risk termed a ‘risk index’ or ‘z-score of
consider such a ratio to be 1 : l for our purposes. Also, see z-scores’ result^.^' This is measured on a 5 point
Altman (1980) for a detailed analysis of bad debt recovery
experience by US banks and a further review of this issue. scale, with ‘1’ indicating a relatively low proba-
’OAs apparently with the dataSTREAM z-model which, by bility of immediate financial distress and ‘5’ a
the beginning of 1982, was classifying as ‘failing’ no less than company usually beyond saving in its present
4 out of 10 of the approximately 1350 companies monitored.
The proportion of companies ‘which may merit further close form. Figure 3 provides the risk index distribution
examination’ according to the Bank of England model was in bar chart form for the average of 92 ‘at risk’
even higher at around 53% of the 809 company sample companies in the EXSTAT files during 1980. Also,
examined (Bank of England, 1982)! The equivalent figure for
the model described here was 19.7% and, for the associated it shows the equivalent distributions for the 22 ‘at
model for the analysis of distribution companies referred to risk’ companies on file that had entered into re-
in footnote 3 supra, 9%. This reflects the differential impact ceivership by the middle of 1981 and for the 15 still
of the recession in the UK on business enterprises. The
weighted average for the total of just under 900 live industrial
and distribution companies in the EXSTAT data-base was 3’See Dawes and Corrigan (1974) for arguments relating to
thus 17% at the beginning of 1982. The ZETA model of why such a judgmentally based and simple approach may be
Altman ef al. (1977) provided a comparable figure of 20% of expected to be very effective in a decision situation. The author
the 2600 companies on COMPUSTAT files, according to is indebted to the referee for suggesting the apt z-score of
Business Week (24.3.80: 106). z-scores epithet.
 AUTUMN 1983 303

Figure 3
Risk index distributions
% of Companies

50

40
Q
"

30
4

20
Downloaded by [University of Glasgow] at 09:02 18 December 2014

10

1980 average at Companies in Companies with

risk company receiver ship going concern
distribution qualifications

Note The number of companies in each category is

placed above each bar

trading at that time which had received going It is instructive to consider why the basic ap-
concern qualifications at some stage. The rating proach works as well as it does. The methodology
system, although simple, appears to be of oper- essentially does little else but combine
ational utility. four appropriately selected and weighted financial
ratios, that are computed directly from the much
criticised conventional published accounting state-
IV Why the solvency model works ments, and allow interpretation of the resulting
As we have seen, the z-model not only exhibits index on the basis of whether it is above or below
discriminant ability but also true predictive ability a specified cut-off.
in a statistical sense. This is because the probability In the first place, as has been stressed, the
of an 'at risk' firm subsequently failing within a approach is principally descriptive in nature, with
year was about 6 times as great as for a firm the derived function made up of a small number of
selected at random in both 1980 and 1977, the 2 important and distinct measures of a company's
years studied. In addition, in the more than 5 years financial state. These, when taken together, pro-
that the model has been in operation to July 1982, vide a multi-dimensional profile which can be
only one firm not classified at risk (z = -0.35) had appropriately transformed into a one-dimensional
actually entered into receivership (in February analogue, uiz: a z-score. The derived function, it
1981) out of the 35 such firms on file. Even in this will be noted, is multivariate in nature, exactly as
case, the circumstances surrounding the company a company's published financial statements are
suggest it may not have been strictly insolvent.32 multivariate documents. Thus, the model is doing
little more than reflecting and condensing the
information conveyed by the set of accounts itself.
It is essentially a device for communicating this
'2All operating assets of this small firm were acquired on
a going concern basis by the company's existing major Swiss holistic set of economic information succinctly and
shareholder once the receiver was appointed. in a readily intelligible manner. By taking into
 304
account the different facets of the information
simultaneously, rather than one at a time as with
conventional ratio analysis, the Hegelian principle
of the whole being greater than the sum of 'the
parts convincingly applies!
The ratios selected by the step-wise discriminant
approach, apart from each effectively measuring a
different aspect of the company under in-
vestigation, are separately less amenable to win-
dow dressing and creative accounting by virtue of
their construction. Additionally, because of the
model's multivariate nature and the swings and
roundabouts of double entry, the results of such
efforts are largely defeated as their effects tend to
be manifested elsewhere in a counter-balancing
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fashion. In any case, such practices are probably
far less widespread than is often thought; a careful
reading of the notes to the accounts for a series of
financial years usually permits their identification
and the appropriate respecification of the original
accounting numbers in a consistent manner. Al-
though alternative treatments of an accounting
item may result in apparently large differences on
an absolute basis, relative to the scale of the item
in question or the size of the company, such effects
are usually far less significant.
In addition, the use of ratio constructs ensures
that the effects of inflation are largely discounted
by virtue of their numerators and denominators
both being affected, at least to a first approxi-
mation, in a similar way. This very important
property of financial ratio data is commonly not
recognised. The solvency function is of course
derived from conventional modified historic ac-
counting data. However, the model is used to
compare the financial profile of a company under
investigation with that of groups of previous
failures or u priori solvent concerns, in relative not
absolute terms. Thus, providing z-scores are com-
puted from accounts drawn up on a similar
modified historic basis, the effects of inflation are
unlikely to reduce significantly the effectiveness of
the model. Certainly no evidence of any appre-
ciable impact has been observed to date.33
Finally, it should be noted that such a dramatic
situation as impending insolvency just cannot be
~~ ~ _ _ _ _ _ _
"None of the small number of empirical studies in the
literature known to the author which have addressed the
problem have demonstrated the superiority of inflation ad-
justed accounting information for the particular decisions of
interest here. See Bazley (1976). Ketz (1978), his discussants
Bildersee (1978) and Patell (1978). Also, see Norton and Smith
(1979), their discussants Solomon and Beck (1980) and the
reply, Norton and Smith (1980). Nevertheless, since all these
studies are US-based, caution must be exercised in generalising
to current cost accounting in the UK.
ACCOUNTING A N D BUSINESS RESEARCH
covered up nowever the accounts are stated (except
by serious and deliberate fraud), given that they
can be correctly read, in a multivariate way.
A theoretical explanation originates with Walter
(1957) who views a firm as a reservoir of liquid
assets (working capital) supplied by inflows and
drained by outflows. Failure can be viewed in
terms of an exhaustion of the liquid asset reservoir
which acts as a cushion against variations in the
different flows.
Essentially, other things being equal, the proba-
bility of failure is higher:
(i) the smaller the size of the reservoir,
(ii) the smaller the funds flow from operations,
(iii) the larger the claims on the resources by
creditors,
(iv) the greater the funds flow required for oper-
ations of the business,
and
(v) the more highly variable the inflows, outflows
and claims on the business.
Considering the constituent ratios of the sol-
vency model, the profitability measure can be
viewed as measuring the funds flow from oper-
ations, the working capital ratio as measuring the
size of the reservoir, the financial risk measure as
measuring the claims on resources, and the no-
credit interval as measuring the funds flow required
to run the business. The colourful but nonetheless
helpful simile of an 'at risk' company being like a
drunkard rolling along a cliff edge in a force nine
gale graphically illustrates the fifth argument.34
V The performance model transform
However valuable a decision tool in its own right,
the z-score's terms of reference are relatively lim-
ited, in that its nature is essentially bifurcated (a
score is either above or below a cut-of). Strictly
speaking, such a function can only indicate that the
company under investigation has a financial profile
more similar to previous failures than to sound
concerns or vice versa, the former being a neces-
sary but not sufficient condition for financial dis-
tress.
Nevertheless, the z-score measures a number of
performance related characteristics of a business.
As such, a company with a higher score may be
viewed as a better performer than one with a lower
value, i.e. the z-score is ordinal. However, because
the measure is non-linear and has no range limits,
''See Scott (1981) for a detailed analysis of the relationship
between empirical corporate bankruptcy prediction models
and various explanatory bankruptcy theories.
 AUTUMN 1983 305

Figure 4
Dunbee-Combex-Marx and toy industry PAS trajectories

PAS -Score
70

60
\ inausrry average
\
50 \
\
\
\
40 Dunbee -Combex- Marx

\
30
Solvent Region
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20

10
. . Sdvency Threshold
At Risk Region

- I I I I I I I
1973 1974 1975 1976 1977 1978 1979 Year

no ratio scale applies. This means that, for exam- overcomes these problems. A company’s PAS (per-
ple, it is not possible to view a z-score of 2 as twice formance analysis score) in a particular year is
as good as a z-score of 1, only that it is better. arrived at by ranking the z-scores of all firms for
Thus, it is not valid to average z-scores to provide that year in ascending sequence and observing the
industry means, nor to work directly with z-score percentile in which the z-score of the concern of
trajectories in an attempt to measure changes in a interest lies-its PAS. Different calculations are
company’s relative performance over time.35 An carried out for each year of data for each company
additional problem is that, as the economy so that the company’s PAS trajectory indicates its
changes, the same z-score will not indicate the relative performance over time.36
same degree of relative strength or weakness. Figure 4 provides a classic trajectory, that of
However a simple transformation that converts Dunbee-Combex-Marx (DCM), the largest UK
the z-score into a ratio measure along a scale &-1OO toy company, together with the PAS arithmetic
average for companies in the toy industry (Stock
Exchange Industry Classification 65) in EXSTAT.
ISThis is the approach adopted by dataSTREAM. The
problems that can arise may be illustrated with an example DCM went into receivership in February 1980
from the dataSTREAM system at the beginning of 1981, that following a strategy of acquisition of large ailing
of a major company in the steel and chemical plant sector: companies overseas. Its PAS declined from 67 (i.e.
Year end: 3/76 3/77 3/78 3/79 3/80 only 33% of companies performing better) on the
Company z: -0.1 -0.2 0.1 -0.5 -0.6
Sector average z: 0.1 0.2 0.3 - 0.2 - 0.6 basis of its 1975 accounts, to 7 (i.e. only 7% of
Market average z: 2.4 2.6 2.3 2.7 2.2 companies doing worse) on the basis of its last
accounts prior to failure. A reflection of the prob-
Apart from the fall in the overall average z-score in 1978,
which would not accord with a priori expectations given the
lems in the toys and games sector is provided by
then state of the economy, it will be noted how difficult it is the industry picture. The ability to interpret the
to interpret both the relative improvement/decline in the PAS directly along a ratio scale (i.e. a PAS of 60
industry performance relative to the overall picture and
particularly the company’s performance relative to its industry.
is twice as good as one of 30) and as a measure of
Did the company’s performance actually improve or decline
between 1979 and 1980 and, if so, by how much? Also it will
be noted that, as the dataSTREAM z-score cut-off is 0, the ‘6Taffler (1981) shows that the PAS explicitly meets all the
average company in steel and chemical plant would be criteria necessary to constitute an efficient and operational
classified as ‘failing’ on the basis in 1979 and 1980. This, again. measure of relative economic performance as required by
does not accord with prior expectations. Shashua and Goldschmidt (1974).
A BR 13/52 t
 306
relative performance will be noted. The solvency
threshold is where z = - 1.95 and represents the
boundary between ‘at risk’ and solvent z-scores.
The percentage of companies ‘at risk’ varies with
the economic climate in line with Table 3.
VI Conclusions
This paper illustrates the multi-dimensional nature
of conventional financial statements and, in a
particular decision situation, the benefits that de-
rive from explicit recognition of this through the
adoption of appropriate multivariate tools of
analysis. A UK-based discriminant function,
termed a z-model, is derived for the evaluation of
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company solvency on the basis of published ac-
counting information alone. This exhibits both
true ex ante predictive ability and clear operational
utility on the basis of its track record to date.
Although the z-model described in this paper
and in particular its derivative risk index can
predict company failure with considerable accu-
racy, the model is more appropriately used in
practice to highlight potential financial distress
while there is still time for recovery actions to be
taken. Use of the PAS transform even permits
companies to be picked up on the basis of their
downward trajectory, well in advance of an ‘at
risk’ profile being registered, thus providing even
earlier warning of an impending insolvency. Ide-
ally, however, such an approach should be self-
defeating. The evidence provided of prospective
demise should concentrate the minds both of those
in the company on the true state of affairs, and
those involved with it who are in a position to
enforce action to ensure short-term survival and
long-term viability, viz. its auditors, bankers,
financial advisors and the shareholding institu-
tion~.~’
This study shows that the conventional, much
maligned, published accounting statements can be
valuable sources of information if (i) the holistic
picture that they present of a company’s financial
state is recognised, (ii) they are read and used in the
correct way, viz. as multivariate documents, and
with the tools appropriate to reflect this, and (iii)
they are considered as presenting the company’s
activities and financial state essentially relative to
those of other concerns not on an absolute basis.
It can be cogently argued that, such are the
cognitive problems confronting the financial state-
ment user in many decision situations, only a
j7A good example of the constructive use of the z-score
approach as an aid to corporate financial recovery is provided
by Altman and La Fleur (1981).
A C C O U N T I N G A N D BUSINESS RESEARCH
formal model is able to provide efficient and
unbiased processing of the complex information
set presented by a set of company accounts. The
benefits that can derive from an explicit ‘man with
model’ approach are legion.
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 308 A C C O U N T I N G A N D B U S I N E S S RESEARCH

JOURNAL OF ACCOUNTING AND ECONOMICS

Editors Associate Editors:

Ross L. Watts Stanley Baiman Robert L. Hagerman James A. Ohlson
Jerold L. Zimmerman Ray Ball Nils H. Hakansson James M. Patell
Downloaded by [University of Glasgow] at 09:02 18 December 2014

William H. Beaver John S. Hughes Katherine Schipper

Consulting Editor:
Robert S. Kaplan
Daniel W. Collins Michael C. Jensen G . William Schwert
Thomas R. Dyckman Richard Leftwich Clifford W. Smith
Eugene F. Fama Baruch Lev Shyam Sunder
Gerald A. Feltham Robert P. Magee Robert E. Verrecchia
George Foster Frank Milne Jerold B. Warner
Jerold A. Wolfson

Table of Contents

August 1983
Vol. 5, No. 2
Editorial Data
Robert W. Holthausen and Richard W. Leftwich
The Economic Consequences of Accounting Choice: Implications
of Costly Contracting and Monitoring
Jerold L. Zimmerman
Taxes and Firm Size
John H. Evans and James M. Patton
An Economic Analysis of Participation in the Municipal Finance
Officers Association Certificate of Conformance Program
William R. Baber
Toward Understanding the Role of Auditing in the Public Sector
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