FINANCIAL STATEMENT ANALYSIS

Financial Statement Analysis:

Financial statement analysis is the process of evaluating the relationship between component parts
of a financial statement to obtain a better understanding of a firm’s position and performance. In
other words, financial statement analysis is largely a study of relationship among the various
financial factors in a business as disclosed by a single set of statements, and a study of the trend of
these factors as shown in a series of statements. In short, it is the technique of x-raying the financial
position and the progress of a concern.

Problems in Financial Statement Analysis:

The following complexities occurred in analyzing the financial statements: • There are different
accounting policies and procedures like LIFO, FIFO, accrual basis vs. cash basis of
accounting, straight line vs. diminishing balance method for charging depreciation, etc.
• Lack of sufficient information because of having multidivisional firms. • Complexion in
international operations for different price level, different accounting methods, different
standards, etc.
• The effect of window dressing, which hides the actual information and reflects a good
condition in short run basis.
• The presence on inflation and disinflation.

• The absence of industry average or industry benchmark or standard performance.

Types of Financial Statement Analysis:

On the basis of the persons interested in the analysis, financial statement analysis may be
classified into following two categories:
1. External analysis: External analysis is the analysis done by the external parties (i.e., parties
who are outsiders for the business). The external parties include investors, lenders,
creditors, etc. who have no access to the books of accounts and the internal records of the
concern. As the external analysts have no access to the books of accounts and the internal
records of the concern, they mainly depend upon the published financial statements for
their analysis.
2. Internal analysis: Internal analysis is the analysis done by the internal parties. The internal
parties include persons who have access to the books of accounts and the internal records
of the concern. As the internal analysis is done by persons who have access to the books of
accounts and the internal records of the concern, internal analysis is more detailed than
external analysis.

On the basis of the method of operation followed financial statement analysis can be of following
two types:
• Cross sectional analysis.

• Time series analysis.

Dr. S. M. Sohrab Uddin, Professor, Department of Finance, CU Page 1 of 13
Cross Sectional Analysis
When the financial statements of one entity are analyzed with other entity at the same point of time
to compare the performance is called cross sectional analysis. Common size statements and
financial ratio analysis are the two techniques that are used for cross sectional analysis.
Applications of Cross Sectional Analysis:
Cross sectional analysis is used in many areas. The following are some of them: • Valuation
analysis for merger/acquisitions where the financial statements of firms are used to make
inferences about the relative under/over valuation of a target firm. • Evaluation of
management performance where one input is the profitability of the firm compared to a
benchmark set of firms operating in the same competitive environment. • Compensation of
executives.
• Prediction of financial distress using models based on firms in the one industry. • Public
policy decisions about excess profits tax legislations where one input is the
profitability of the firm compared to that of firms in other
industries.
Approaches to Define Similar Entity for Cross Sectional Analysis:
Cross sectional comparisons of the financial statements of firms and other entities require choices
about the set of comparables. The following illustrate alternative approaches to define similar
entity:
• Similarity on supply side: Firms may be grouped on the basis of having similar raw
materials, similar production process, similar distribution network and so on. • Similarity on
demand side: This approach emphasizes similar in terms of end-product similarity and the
perceptions of customers as to the substitutability of products. According to this approach,
the comparison can be made between companies producing similar products.
• Similarity in capital market attributes: This approach is discussed from the investment
perspective as stocks that have similar attributes such as risk, price to earnings ratios, or
market capitalization may be of interest.
• Similarity in legal ownership: An important managerial use of cross sectional analysis is in
allocating the resources between different subsidiaries. These subsidiaries may be quite
diverse in terms of both demand and supply sides. Similarity arises from being owned by
a same set of shareholders.
Problems in Collecting Data for Cross Sectional Analysis:
Many difficult problems can arise in the data collection phase of a cross sectional analysis. The
following are some of them:
1. Non-availability of data: A frequent problem is that data are not available for the entities
of interest. The main reasons for this are as follows:
• The entity is privately held so no publicly released financial statement information
is available.
• The entity is owned by a foreign company.
 • The entity is owned by a multiactivity company that provides limited financial
disclosures relating to the entity.
2. Non-uniformity of accounting method: In many samples of firms, diversity in accounting
method choice is encountered.

Dr. S. M. Sohrab Uddin, Professor, Department of Finance, CU Page 2 of 13

3. Non synchronous reporting period: This problem arises when all firms in the sample do
not have comparable fiscal year ends and also differ in the periodicity of interim reporting.
Common Size Statements:
One impetus to the development of the common-size statement came from the problems in
comparing the financial statement of firms that differ in size. Suppose that Company A has long
term debt of Tk.76 million and that Company B has long-term debt of Tk.60 million. Due to
possible size differences between the two companies, it would be misleading to always infer that
A was more highly leveraged than B. One way of controlling for size differences is to express the
components of the balance sheet as a percentage of total assets (liabilities + equity) and the
components of the income statement as a percentage of total revenues. The derived statements are
termed common-size statements. Common-size financial statements are also known as component
percentage statements or 100 percent statements, because each individual item is expressed as a
percentage of the total of 100. This technique is also referred to as vertical analysis or static
analysis given the op-down (or down-up) movement of our eyes as they review the statements.
Common-size statements can be of following two types:
1. Common-size balance sheet: It means the statement where each component of assets,
equity, and liabilities are expressed as a percentage of total assets.
2. Common-size income statement: It means the statement where each component of
expenditures and income are expressed as a percentage of total revenues.
The common-size statement reflects accounting method differences as well as financing,
investment, and operating differences across the two or more companies. It is important mainly for
the following two reasons:
• To control the problems for the size differences.

• To make the comparison between firms and with in firm effectively.

Problem 1:
You are given the following Income Statement and Balance Sheet of A Co. Ltd. and B Co.
Ltd. Income Statement
For the year ended 31st December 2004
A Co. Ltd. B Co. Ltd.

Sales 22,00,000 21,00,0

Less: Cost of Goods Sold 11,60,000 00
12,60,0
00

Gross Margin 10,40,000

Less: Operating Expenses 7,60,000 8,40,00
0
 6,60,00
0

Operating Income 2,80,000

Less: Interest Expenses 80,000 1,80,00
0
30,000

Net Income Before Tax 2,00,000

Less: Income Tax @ 30% 60,000 1,50,00
0
45,000

Net Income 1,40,000 1,05,000

Balance Sheet
As on 31st December 2004
Assets A Co. B Co. Equity and A Co. B Co.
Liabilities

Cash 20,000 21,000 Accounts 1,20,00 2,00,000

Accounts Receivable 1,80,00 1,69,00 Payable Long- 0 3,00,000
0 0 term Bonds 4,80,000

Dr. S. M. Sohrab Uddin, Professor, Department of Finance, CU Page 3 of 13

Merchandise 3,50,000 3,00,000

Inventory

Current Assets 5,50,000 4,90,000 Total Liabilities 6,00,000 5,00,000

Property and 9,00,000 8,10,000 Common Stock 5,00,000 5,00,000

Equipment Retained Earnings 3,50,000 3,00,000

Total Assets 14,50,000 13,00,000 Total Liabilities 14,50,000 13,00,000

and Equity

You are required to:

i. Prepare a Common-size Balance Sheet and a Common-size Income Statement. ii. Compare the
financial position of the companies in terms of cost of goods sold, net income, current assets,
long-term bonds, and equity.
Solution:
Common-size Income Statement
For the year ended 31st December 2004
 Particulars A Co. Ltd. B Co. Ltd.

×= ×=
Sales 22,00,000 21,00,000
100 100% 100 100%
Less: Cost of Goods Sold 22,00,000 21,00,000
×= ×=
11,60,000 12,60,000
100 52.73% 100 60%
22,00,000 2100,000

×= ×=
Gross Margin 10,40,000 8,40,000

Less: Operating Expenses 100 47.27% 100 40%

22,00,000 21,00,000
×= ×=
7,60,000 6,60,000
100 34.55% 100 31.43%
22,00,000 21,00,000

×= ×=
Operating Income 2,80,000 1,80,000
100 12.73% 100 8.57%
Less: Interest Expenses 22,00,000 21,00,000
×= ×=
80,000 30,000
100 3.64% 100 1.43%
22,00,000 21,00,000

×= ×=
Net Income Before Tax 2,00,000 1,50,000
100 9.09% 100 7.14%
Less: Income Tax @ 30% 22,00,000 21,00,000
×= ×=
60,000 45,000
100 2.73% 100 2.14%
22,00,000 21,00,000

×= ×=
Net Income 1,40,000 1,05,000
100 6.36% 100 5.00%
22,00,000 21,00,000

Common-size Balance Sheet

As on 31st December 2004
 Particulars A Co. Ltd. B Co. Ltd.

×= ×=
Cash 20,000 21,000
100 12.41% 100 13.00%
14,50,000 13,00,000

Dr. S. M. Sohrab Uddin, Professor, Department of Finance, CU Page 4 of 13

×= ×=
Accounts Receivable 1,80,000 1,69,000

Merchandise Inventory 100 1.38% 100 1.62%

14,50,000 13,00,000
×= ×=
3,50,000 3,00,000
100 24.14% 100 23.08%
14,50,000 13,00,000

×= ×=
Current Assets 5,50,000 4,90,000
100 37.93% 100 37.69%
14,50,000 13,00,000

×= ×=
Property and Equipment 9,00,000 8,10,000
100 62.07% 100 62.31%
14,50,000 13,50,000

×= ×=
Total Assets 14,50,000 13,00,000
100 100% 100 100%
14,50,000 13,00,000

×= ×=
Accounts Payable 1,20,000 2,00,000
100 8.28% 100 15.4%
Long-term Bonds 14,50,000 13,00,000
×= ×=
4,80,000 3,00,000
100 33.10% 100 23.08%
14,50,000 13,00,000

×= ×=
Total Liabilities 6,00,000 5,00,000
100 41.38% 100 38.46%
14,50,000 13,00,000
 ×= ×=
Common Stock 5,00,000 5,05,000
100 34.48% 100 38.46%
Retained Earnings 14,50,000 13,00,000
×= ×=
3,50,000 3,00,000
100 24.14% 100 23.08%
14,50,000 13,00,000

×= ×=
Total Liabilities and Equity 14,50,000 13,00,000
100 100% 100 100%
14,50,000 13,00,000

Problem 2:
From the following information:
i. Prepare a common-size Income Statement and a common-size Balance Sheet for the Company
X and Company Y.
ii. Compare the financial position of the companies in terms of cost of goods sold, net income,
current assets, long-term bonds, and equity.
Income Statement
For the year ended 31st December 2004 & 2005
Company X Company Y

Sales 22,000 22,800

Less: Cost of Goods Sold 11,600 11,700

Gross Margin 10,400 11,100

Less: Operating Expenses 7,600 8,000

Operating Income 2,800 3,100

Less: Interest Expenses 800 1,000

Net Income Before Tax 2,000 2,100

Less: Income Tax @ 30% 600 650

Dr. S. M. Sohrab Uddin, Professor, Department of Finance, CU Page 5 of 13

Net Income 1,400 1,450

Balance Sheet
As on 31st December 2004 & 2005
 Assets Co. X Co. Y Equity and Liabilities Co. X Co. Y

Cash 200 500 Accounts Payable 1,200 1,000

Accounts 1,800 1,500 Long-term Bonds 5,800 6,800
Receivable 4,500 3,000
Merchandise
Inventory

Current Assets 6,500 5,000 Total Liabilities 7,000 5,800

Property and 9,000 11,300 Common Stock 5,000 5,000

Equipment Retained Earnings 3,500 3,000

Total Assets 15,500 16,300 Total Liabilities and 15,500 16,300

Equity

Financial Ratio Analysis:

The most widely used cross-sectional technique is a comparison of ratios across firms. Numerous
individual ratios have been used. The following seven categories and ratios within each category
are applied. The seven categories are (i) cash position, (ii) liquidity, (iii) working capital/cash flow,
(iv) capital structure, (v) debt service coverage, (vi) profitability, and (vii) turnover.
Cash Position:
Cash and marketable securities form an important reservoir that the firm can use to meet its
operating expenditures and other cash obligations when and as they fall due. The ratios that have
been used when comparing the relative cash positions of different firms include: Cash +
Marketablesecurities

•
Current liabilities

Cash + Marketablesecurities

•
Sales

Cash + Marketablesecurities

•
Total assets
The higher each of these ratios, the higher the cash resources available to the firm.
Liquidity:
Liquidity refers to the ability of a firm to meet its short-term financial obligations when and as they
fall due. The cash position ratios discussed capture one dimension of liquidity. Two additional
liquidity ratios are frequently used are:
 ·+ +
Quick ratio =
securities accountsreceivable

Cash Short - term marketable

•
Currenct liabilities

Currenct ratio =·
Currenct assets

•
Currenct liabilities
Both ratios extend the assets in the numerator of the cash position ratios to include items that
potentially can be converted into cash. The quick ratio includes accounts receivable (cash + short
term marketable securities + accounts receivables are often called the “quick assets”). The current
ratio also includes in the numerator items such as inventories and prepaid expenses. The higher
both the ratios, the higher the liquidity position of the firm.

Dr. S. M. Sohrab Uddin, Professor, Department of Finance, CU Page 6 of 13

Working Capital/Cash Flow:
Increasing attention is being paid to the cash-generating ability of firms. While most firms do not
directly report cash flow information in their annual reports, inferences about cash flow can be
gained by adjusting the reported net income figure for the noncash items in its computation. The
following table presents a set of adjustments to compute “working capital from operations” and
“cash flow from operations”.
Financial ratios that incorporate these two concepts include:
Working capital from operations

•
Sales
Working capital from operations

•
Total Assets
Capital Structure:
Capital structure ratios provide insight into the extent to which nonequity capital is used to
finance the assets of the firm. Some representative ratios are as follows:
Long term liabilities
−

•
Shareholder s equity
'
Current liabilities long term liabilities
+−
 •
Shareholder s equity
'
The higher each of these ratios, the higher the proportion of assets financed by non-shareholder
parties.
Debt Service Coverage:
Debt service coverage refers to the ability of an entity to service from its operations interest
payments that are due to nonequity suppliers of capital. The ratio useful in making inferences about
coverage is:
Operating income

•
Annual erest payments
int
The higher this ratio, the greater the ability to service interest payments to external parties.
Profitability:
Profitability refers to the ability of a firm to generate revenues in excess of expenses. When
making comparisons across firms (or over time), it is useful to control for differences in their
resource base. The following three ratios illustrate alternative ways of expressing relative
profitability: Net income

•
venues
Re
Net income

•
Shareholder s equity
'
Net income

•
Total assets
The net income-to-revenue ratio indicates how much net income is earned from each amount of
revenue. The net income to shareholder’s equity ratio (sometimes shortened to return on equity
ratio) measures the efficiency with which common shareholder’s equity is being employed within
the firm. The net income-to-total assets ratio measures the efficiency with which assets are
employed within the firm. The higher each of these of ratios, the more profitable the firm in a
relative sense.

Dr. S. M. Sohrab Uddin, Professor, Department of Finance, CU Page 7 of 13

Turnover:
Various aspects of the efficiency with which assets are utilized can be gleaned from turnover
ratios as well as from several of the previous ratios. One such ratio is the total asset turnover
ratio: Sales
 •
Total assets
This ratio indicates how many times annual sales cover total assets. In examining this ratio, it is
important also to examine the related net income-to-sales ratio. Firms may trade off an increase in
the total asset turnover ratio for a decrease in the net income-to-sales ratio.
A second turnover ratio is the accounts receivable turnover ratio:
Sales

•
Accounts receivable
As accounts receivable pertain only to credit sales, it is often recommended that the numerator
include only credit sales. In many cases, however, total sales are used due to the breakdown of
cash and credit sales not being provided in published annual reports. By dividing 365 by the
accounts receivable turnover ratio, one obtains an estimate of the average collection period of
credit sales.
A third turnover ratio is the inventory turnover ratio:
Cost of goods sold

•
Inventory

Capital Market Information:

By examining changes over time in market capitalization (market price per equity share×number
of common shares outstanding), insight can be gained about changes in the consensus expectation
of the relationship between future and current profitability. The price-to-earnings (PE) ratio is a
frequently used figure in this analysis:
Markett capitalization of equity shares

•
Net income available to common
The higher the price-to-earnings ratio, the higher the expected future income relative to the
current reported income.
A second capital market variable frequently used is dividend payout
ratio: Dividends paid

•
Net income

Time Series Analysis.

In financial analysis the direction of changes over a period of years is of crucial importance. Time
series analysis indicates the direction of change over time. A time series is a set of observations
taken at specified times usually at equal intervals. It involves the ascertainment of arithmetic
relationship with each item of several years to the same item of base year. Thus, one particular year
out of many years is taken as base. The value of one particular item out of several items shown in
the financial statements are converted into ratios or percentage taking of that item in the base year
as equal to 100. Trend statements and financial ratios are the two techniques that are used for time
series analysis.
Dr. S. M. Sohrab Uddin, Professor, Department of Finance, CU Page 8 of 13
Importance/Utility of Time Series Analysis:
Time series analysis is a useful analytical device, since it reduces the large amounts of absolute
data into simple and easily readable percentage. It is immensely helpful to the management in
knowing the present position and the trend or direction in which the enterprise is moving. Through
a study of the time series over a period of time, the management can know whether the enterprise
is moving upward or going downward or remaining constant. It is extremely helpful in budgeting,
forecasting, etc.

Trend Statements:
Constructing trend statements involves choosing one year as a base and then expressing the
statement items of subsequent years relative to their value in the base year. As a conversion, the
base year is given a value of 100. It refers to the general direction of the data indicating the decrease
or increase during a long period of time.
Problem 3:
You are given the following information of George Company:
George Company
Income Statement
For the year ended 31st December 2001, 2002, 2003, & 2004
2004 2003 2002 2001

Sales 22,00,0 21,00,0 25,00,0 29,00,0

Cost of Goods Sold 00 00 00 00
Operating Expenses 11,60,0 12,60,0 13,00,0 14,00,0
Interest Expenses 00 00 00 00
8,40,00 10,40,0 10,00,0
7,60,00 0 00 00
0 66,000 80,000 1,00,00
28,000 0

George Company
Balance Sheet
As on 31st December 2001, 2002, 2003, & 2004
2004 2003 2002 2001

Assets

Cash 20,000 21,000 22,000 20,000

Accounts Receivable 1,80,00 1,69,00 1,75,00 2,00,00
Merchandise Inventory 0 0 0 0
3,50,00 3,00,00 4,00,00 4,20,00
0 0 0 0

Property and Equipment 9,00,000 8,10,000 10,00,000 11,00,000

Total Assets 14,50,000 13,00,000 15,97,000 17,20,000

 Equity and Liabilities

Accounts Payable 1,50,000 1,50,000 1,50,000

Long-term Bonds 1,20,00 2,80,000 5,00,000 6,80,000
0
4,80,00
0

Common Stock 5,00,000 5,00,000 5,00,000

Retained Earnings 5,00,00 3,70,000 4,47,000 4,00,000
0
3,50,00
0

Total Liabilities and Equity 14,50,000 13,00,000 15,97,000 17,20,000

Prepare trend statements for the above-mentioned variables considering 2001 as base.
Solution:
George Company

Dr. S. M. Sohrab Uddin, Professor, Department of Finance, CU Page 9 of 13

Trend Statement for Income Statement
2004 2003 2002 2001

×= ×=
Sales 22,00,000 21,00,000 86.21% 100%

100 75.86% 100 72.41%

29,00,000 29,00,000

×= ×=
Cost of Goods Sold 11,60,000 12,60,000 92.86% 100%

100 82.86% 100 90%

14,00,000 14,00,000

×= ×=
Operating Expenses 7,60,000 8,40,000 104% 100%

100 76% 100 84%

10,00,000 10,00,000

×= ×=
Interest Expenses 28,000 66,000 80% 100%

100 28% 100 66%

1,00,000 1,00,000

George Company
Trend Statement for Balance Sheet
 2004 2003 2002 2001

Assets

×= ×=
Cash 20,000 21,000 110% 100%

100 100% 100 105%

87.50% 100%
Accounts Receivable 20,000 20,000
95.24% 100%
Merchandise Inventory
90% 84.50%
83.33% 71.43%

Property and Equipment 81.82% 73.64% 90.90% 100%

Total Assets 84.30% 75.58% 92.83% 100%

Equity and Liabilities

Accounts Payable 85.71% 107.14% 107.1 100%

Long-term Bonds 70.59% 41.18% 4% 100%
73.53
%

Common Stock 100% 100% 100% 100%

Retained Earnings 87.50% 92.50% 111.75% 100%

Total Liabilities and Equity 84.30% 75.58% 92.85% 100%

Problem 4:
From the following information of Hindustan Industries Ltd. prepare trend statements for the
above-mentioned variables considering 2000 as base.
Hindustan Industries Ltd.
Income Statement
For the year ended 31st December 2000, 2001, & 2002
2000 2001 2002

Sales 6,00,000 8,00,000 10,00,0

Cost of Goods Sold 3,00,000 5,00,000 00
Selling Expenses 1,00,000 1,50,00 6,00,00
Administrative Expenses 50,000 0 0
Financial Expenses 30,000 2,00,00
60,000 0
40,000 80,000
20,000

Hindustan Industries Ltd.

 Balance Sheet
st
As on 31 December 2000, 2001, & 2002
2000 2001 2002

Dr. S. M. Sohrab Uddin, Professor, Department of Finance, CU Page 10 of 13

Share Capital 2,00,000 2,50,000 3,00,000

Reserves 1,00,000 1,50,00 1,50,00
Loans 2,00,000 0 0
Accounts Payable 1,00,00 50,000
Buildings 3,00,00 0 2,00,000
Plant 0 4,00,0 3,00,000
Stock 2,00,00 00 1,00,00
Accounts Receivable 0 2,50,0 0
Cash at Bank 2,00,00 00 1,50,00
0 2,50,000 0
2,50,00 2,50,000 1,00,00
0 1,00,00 0
1,00,00 0 50,000
0 50,000
50,000

Financial Ratios Analysis:

Analysis of time series trends in financial ratios is another technique used in financial statement
analysis.
Problem 5:
The current ratio of Bengal Ltd. from the year 1995 to 2004 are given
below: 1.59, 1.78, 2.03, 1.93, 2.23, 2.13, 1.83, 1.79, 2.05, 1.65 respectively.
Requirements:
1. Calculate the estimated current ratio of 2005 by using least square method.
2. Draw the trend line of current ratios from 1995 to 2004.
3. Find the three-year moving average of the ratios and make a comment about the liquidity
position of the company.

Variability Measurement:
An approach that is gaining popularity is to compute variability measures for financial ratios and
other variables over time. One object is to expand beyond one fiscal year the information
contained in a single ratio measure. The formula for measuring variability is as follows:
Variability−
Maximum value Minimum value

=
Mean financialratio
Problem 6:
You are given the following information on the Price Earnings Ratio of AB, CD, EF, and GH Inc.
 Company 1999 2000 2001 2002

AB 8.39 7.97 11.52 13.86

CD 7.30 8.60 10.84 8.68
EF 8.57 7.07 10.68 7.94
GH 9.65 (5.39) 62.00 12.82

Which company’s Price Earning’s ratios are highly volatile? [Ans. GH]

Financial Distress and Its Indicators:

Financial distress means severe liquidity problems that cannot be resolved without a sizeable
rescaling of the entity’s operations or structure. In other words, financial distress asserts the
financial condition of a given company indicating whether it is going to bankruptcy, failure to
make short term payments of creditors, deferred on interest payment of bonds, deferred to pay
short- and long-term fixed obligations, omissions of preferred dividends, and so on. There are
several indicators of, or information sources about, the likelihood of financial distress. The
following are some of them:

Dr. S. M. Sohrab Uddin, Professor, Department of Finance, CU Page 11 of 13

• One source is a cash flow analysis for the current and future periods. One benefit of using
this information source is that it focuses directly on the financial distress notion for the
period of interest.
• A second source of information about financial distress is a corporate strategy analysis. This
analysis considers the potential competitors of the firm or institution, its relative cost
structure, plant expansion in the industry, the ability of the firm to pass along cost increases,
the quality of management, and so on.
• A third source of information about financial distress is an analysis of the financial statements
of the firm and those of comparison set of firms. This analysis can focus on a single
financial variable (univariate analysis) or on a combination of financial variables
(multivariate analysis).
• A fourth source of information comes from external variables such as security returns and
bond ratings.
Importance of Financial Distress for Different Parties:
Parties that can utilize the prediction of the financial distress of corporations are discussed below:
• Lenders: Financial distress prediction has relevance to lending institutions, both in deciding
whether to grant a loan (and its conditions) and in deciding policies to monitor existing loans.
• Investors: Distress prediction models can be of assistance to investors in debt securities when
assessing the likelihood of a company experiencing problems in making interest or
principal repayments.
• Regulatory authorities: In certain industries, regulatory bodies have the responsibility of
monitoring the solvency and stability of individual companies.
 • Auditors: One judgment auditors must make is whether s firm is a going concern. This
judgment affects the asset and liability valuation methods that are deemed appropriate for
financial reporting.
• Management: If early warning signals of bankruptcy are received, management can arrange
a merger with another firm or adopt a corporate reorganization plan at a more propitious
time.
Edward I. Altman’s Z Score Model:
This multivariate model divides corporations into high or low bankrupt risk classes’ contingent on
their observed characteristics. It was developed by Edward I. Altman for publicly traded
manufacturing firms in the United States. The indicator variable Z is an overall measure of the
bankrupt risk classification of the borrower. That, in turn, depends on the values of various
financial ratios of the corporations and the weighted importance of these ratios based on the past
observed experience of defaulting versus nondefaulting corporations. Altman’s discriminant
function takes the following form for publicly traded companies:
12340 5Z=1.2X +1.4X + 3.3X + 0.6X +1. X
Where, X1 = Working capital/total assets ratio.
X2 = Retained earnings/total assets ratio.
X3 = Earnings before interest and taxes/total assets ratio.
X4 = Market value of equity/book value of total liabilities.
X5 = Sales/total assets ratio.
Altman’s discriminant function takes the following form for non-publicly traded companies:

Dr. S. M. Sohrab Uddin, Professor, Department of Finance, CU Page 12 of 13

1 2 3 4 998 5 Z = 0.717X + 0.847X + 3.107X + 0.420X + 0. X

The cutoff points Altman reported for publicly traded and non-publicly traded firms were:
Nonbankrupt Bankrupt Neutral/Gray area

Publicly traded firms Z > 2.99 Z < 1.81 Z = 1.81 to 2.99

Non-publicly traded firms Z > 2.90 Z < 1.20 Z = 1.20 to 2.90

Altman notes that any publicly traded firm with Z-score below 1.81 is considered to be a prime
candidate for bankruptcy, and the lower the score, the higher the failure probability. On the other
hand, any non-publicly traded firm with Z-score below 1.20 is considered to be a prime candidate
for bankruptcy, and the lower the score, the higher the failure probability
Suppose that the financial ratios of a publicly traded firm took the following values:
X1 = 0.2, X2 = 0, X3 = -2.0, X4 = 0.10, and X5 = 2.0
The Z score for the firm = 1.2×0.2 +1.4×0 + 3.3×(−2.0) + 0.6×0.10 +1.0×2.0
= 1.64.
Thus, the firm is in financial distress according to the multivariate z-score model.
Problem 7:
On the basis of information given in problem 1, you are required to do the following: 1. Find the
value of1 2 3 4 0 5 Z =1.2X +1.4X + 3.3X + 0.6X +1. Xfor A Co. and B Co. Assume the market
value of equity of A Co. and B Co. are Tk.7,50,000 and Tk.10,00,000 respectively. [Ans. For
Co. A, Z = 3.598; and For Co. B, Z = 3.86]
2. Comment on your calculation regarding future financial distresses.

Dr. S. M. Sohrab Uddin, Professor, Department of Finance, CU Page 13 of 13