Dynamic Strategy - Academic - Predicting Financial Distress and Evaluating Long-Term Solvency: An Empirical Study by S.C. Bardia

Professor S.C. Bardia, Department of Accountancy and Business Statistics, University of Rajasthan, Jaipur, India made an empirical study on two leading steel manufacturing companies of India, Steel Authority of India Limited (SAIL), a public sector undertaking, and Tata Steel Limited, the largest private sector company. In the article “Predicting Financial Distress and Evaluating Long-Term Solvency: An Empirical Study,” S.C. Bardia wrote about his study which aims at predicting bankruptcy or financial distress and evaluating the long-term solvency position of the two companies.

Several standardized tools and techniques have been used in this research. To measure solvency, the author has utilized the technique of common size analysis for both liabilities and assets of the two sample companies to examine the composition of liabilities and assets. The researcher also used the accounting technique of ratio analysis to infer the solvency of the companies. To examine the significance of difference in respect of six solvency ratios he further used the statistical technique of hypothesis testing (also called t-test). Thus, by using statistical tools, the six capital structure and leverage ratios, S.C. Bardia has evaluated the solvency of the two companies. He also used the Altman’s Z-score model to examine the financial distress of the companies during the study period.

One of the key finding of this research is to predict the financial distress or bankruptcy by Altman’s Z-score model which utilizes five financial ratios. The Altman’s Z-score is formulated as below:

Z = 0.717X1 + 0.847X2 + 3.107X3 + 0.420X4 + 0.998X5

In this formula, X1, X2, X3, X4 and X5 can be viewed to reflect liquidity, age of firm, profitability, financial structure and capital turnover, respectively. And:

X1 = Working Capital/Total Assets;

X2 = Retained Earnings/Total Assets;
X3 = EBIT/Total Assets;
X4 = Net Worth/Total Liabilities; and
X5 = Sales/Total Assets

 The Z-Score can be interpreted as:

1. If Z-Score is less than 1.20, it suggests high chances of bankruptcy;
2. If Z-Score is between 1.2 and 2.9, it suggests that the firm is in gray or ambiguous area; and
3. If Z-Score is more than 2.90, it implies low chances or no chances of bankruptcy.

During the period from 1997 to 2009, the Altman’s Z-Scores of SAIL and Tata have never been greater than 2.90, which mean that the two companies were never clearly away from financial distress or bankruptcy. But solvency position of Tata Steel was better than SAIL’s. The research paper thus, suggest the management of the two companies review their solvency positions carefully and take remedial measures immediately in order to avoid the risk of loss of capital, stakeholders’ confidence and goodwill.

This research is a good tool for examining long-term solvency and predicting financial distress of a company. Practicing executives or managers should notice the importance of financial analysis in order to find out areas that may detect the financial problems of their companies.

References

Bardia, S. C. (2012). Predicting Financial Distress and Evaluating Long-Term Solvency: An Empirical Study. IUP Journal Of Accounting Research & Audit Practices, 11(1), 47-61.