Predictions of Corporate Failure

The ability to predict corporate failure will be of interest to many stakeholders such as shareholders, lenders, suppliers, management, employee, etc. For example, banks and other lenders need to monitor loans and creditworthiness of customers, auditors need to assess the going-concern status of their clients and the companies themselves need to assess whether they are in danger of financial crisis.

Major cause of corporate failure is insolvency, which is inability to pay debts when they fall due. There are a number of reasons for a company to experience insolvency.

• One reason is overtrading which leads to shortage of working capital.
• Another is when a company invests heavily and is not able to recover its investment or earn a fair return, owing to changes in the business and economic environment and the company is not able to respond to the changes.
• Loss of major customers is also a reason, and
• Excessive amount of bad debts could lead to insolvency.

Over the last five decades considerable research has been made to determine the extent to which ratio analysis may help predict corporate failure. Often the various key ratios calculated have been done one ratio at a time. They have been grouped on some basis for inter-company comparison or comparison of performance or postion over a period fo time. It is possible to take a combination of a number of key ratios and calculate a score which is compared to a predetermined target or pass mark. When a company scores above the threshold pass mark then it is considered safe. This is referred to as multi-variate analysis or Z-score analysis. A number of models were developed to use key ratios to determine corporate failure. To date the two best-know Z-scores are Altman's Z-score and Taffler's Z-score.