The Journal of Grey System 2 (2006) 133-142

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Grey Target Model Appraising Firms' Financial Status based on Altman Coefficients
Feng Jianyou', Zhang
1. 2. Management School, University of Science and Technology of China, Hefei, 233000, China College of Accountancy, Anhui Univeristy of Finance and Economics, Bengbu, 233041, China

Received December 2005

Abstract Allowing for uncertainty and the non-typical distribution data, tliis paper introduces the grey target model to appraise firms' fmancial status and using the so-catled Altman coefficients in the classical Z score model as the weights. The approach to constructing the grey target by combining the model series needed to be appraised with those reference models, is proposed, which may serve as a general way to forecast and appraise firms' financial status and other similar systems. Keywords: Financial status; Grey target; Altman coefficients; Reference firms.

Introduction
How to appraise and forecast firms' financial status (saying, the financial distress, financial crisis and bankruptcy of a firm) reasonably, is of great importance not only for appraising itself, but for helping construct effective financial alarming system, thus decreasing the possibility of financial distress, protecting the stakeholders' interests, and monitoring the risks of fmancial markets. The present models appraising firms' financial status or estimating firms' financia^l distress, i.e. the linear identification model, the linear probability model, the Logistic regression model and the BP network model, though have been widely used, are based on large sample and typical distribution data. Allowing for uncertainty and non-typical distribution ofthe fmancial data, we introduce the grey target model pioneered by Prof Deng [1~5], combining with the Altman coefficients [6~8], to appraise firms' financial status, which may serve as a general approach to appraising firms' financial status, and the similar systems. Moreover, we introduce the reference companies and use the RDF

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to determine the distinguishing coefficient [9] in this appraisement context. Specifically, we do such work in this paper as following: 1. Introducing the grey target model to appraise firms' financial status, and using the Altman coeflFicients of the classical financial status appraising model as the weights of the indexes in the grey target model. 2. Constructing the grey target model by combining the reference (standard) firms whose financial status have already been well-appraised with those firms needed to be appraised.

Constructing the Grey Target Model Appraising Firms' Financial Status

The weights of the indexes in grey target model Suppose that the target needed to be appraised is denoted by V, the relationship between the target and its infiuencing factors /], h ...,/ takes the form as the following:

V(Iuh
^ = { 1 , 2, ..., m}, where

....In)

The grey target coefficients are denoted, respectively, by ro,{\), /o/(2), ..., roii"

I Xoik)-X;(k) I +CT T
In the classical grey target model, it is generally assumed that each index of the grey target plays the same role in affecting the grade of the target center, which can be denoted by 1 "

ro,=-Sro,(^)This is, however, not always the case. Specifically, when Iu I2 roles in affecting the "target function" F (/,, /j ...,/ play different ..., /), it may be more reasonable to

attribute different weights to different indexes, i.e. let w^ represent the relative "significance" of index/t (keN, N={\, 2, ..., }, then the grade of the target center can be denoted by

{keN,ieM).

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Specially, if w,=wy, ^iJ&N, it is the same as the classical case. In practice, there exist different ways to determine the "significance" of index 4 {keN, N={\, 2,...,}. Typically, the following approaches can serve as the references: 1. The Delphi approach In some cases, it may be more advisable to determine the "significance" of the indexes by the experts, though this approach may be subjective any easy to be manipulated by the experts. 2. Historical data Another feasible and effective way to determine the relative "significance" of the different indexes Wk is making use of the regression coefficients as the proxies of Wk, keN, N={\, 2, ..., }. For instance, the regression equation, in terms ofthe historical data, takes the forms as V = ai/i +a2l2 .... +aJn + s where a^, keN, N={\, 2,...,} represents the regression coefficients, and fthe random error. Then let where a^ >0, we take the index Ik in grey target model as the maximum polarity, while when ak <0, we take the index Ik as minimum polarity. Here, to appraise firms' financial status, we determine the weights ofthe indexes in grey target model in terms of the Altman coefficients in the classical Z score model, namely F = 1.27] + 1.4/2 + 3.3/3 + 0.6/4 +1.0/5 or V= Q.1\1I\ + 0.847/2 -^ 3.IO7/3 + O.42O/4 +O.998/5 where /^working capital/total assets, /2=retained earnings/total assets, /2=EBIT/total assets, /4=the book value of equity/the book value of debt, /5=revenues/total assets. The first model was proposed by Altman in 1969 [6] while the second in 2000 [8]. In this context, we use the regression coefficients as the proxies of wt in terms of the second equation, while we can do the same by using the first one. In the Z score model, for the target needed to be appraised V, each index Ii,l2,...,h has maximum polarity. Determining the reference firms The reference firms, whose financial status is well-assessed, are viewed as the references to appraise those firms needed to be appraised. Generally speaking, when choosing the reference firms, the following factors should be taken into account: 1. The precision of appraisement needed

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2. The number of the fiims needed to be appraised 3. The reference firms should be typical and should include different types as possible In practice, we can often choose, the following types of firms as the reference firms. 1. The company operates well ^i 2. The company with average financial status k2 3. The company dose not operate well ^3 4. The company in financial distress k^ In order to get more precise appraisement, more reference firms may be needed. The RDF and RDC In the system appraising firms' financial status via grey target model, the better the reference firm's financial status, the greater the grade of target center should be. But in practice, this is not always the case. For instance, there may exist the abnormality that the grade of target center of the reference firm whose financial status is better, is less. But this abnormality can be excluded in most cases by making use of RDF (Revealed Distinguishing Field) to determine the distinguishing coefficient in grey target model [9]. The rationale of determining the RDF is determining the possible range of the distinguishing coefficient in terms of the revealed or whitened order of reference systems, thus making the priority of the reference systems reasonable. For instance, in this financial status appraisement context, it's obvious that

But if we let the distinguishing coefficient ^ equal 0.5, we do not necessarily get the exact same order as shown above, while if we use RDF to determine the distinguishing coefficient, we can avoid, more often than not, this abnormal case. The details refers to [91Calculating the grade of target center by combining the firms with to be appraised the reference firms Here we assume that the number of the firms needed to be appraised is /, denoted by ka, ka, ..., kit respectively. Similarly, the weight of index 4 w* {k&N ={\, 2, ..., n}), is substituted by the respective Altman coefficient.'Suppose the grades of target center of the firms needed to be appraised ka, ka, ..., ku are denoted, respectively, by

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;t)/v7e{^ii.*/2,

,kii}

while those ofthe reference firms ^i, ki, h, k^ are denoted, respectively, by
| ' /otj ' y^ky '

Then we have

Appraising the financial status of the firms Appraising the financial status ofthe firms needed to be appraised ki\, ka, ..., ku in terms ofthe respective grades of target center yoj,j {ka, ki2, ..., ku } by comparing with those of the reference firms ku k2, h, k^, saying ro*, > 7'otj > ?'ot,'/o*, The grades of target center of the firms needed to be appraised and of the reference firms are calculated in the same grey target space, so if the grade of target center of one firm is closer to that of a reference firm than to that of another, it's reasonable to assume that the characteristics of the financial status of the former are more similar to that of the reference than the latter. Specifically, in this paper we can investigate the following cases:

In this case, we can reasonably assume that the firm needed to appraised operates very well, and its financial status is better than (or at least the same as) that of the reference firm k\, whose financial status is also very good.

In this circumstance, we can reasonably assume that the firm needed to be appraised operates pretty well, and its financial status is better than (or at least the same as) that of the reference firm ^2, whose financial status is just at the average level, and worse than (or at best the same as) that ofthe reference firm ku whose fmancial status is also very good.

In this case, we can assume that the firm needed to appraised operates not very well, and its financial status is worse than (or at best the same as) that of the reference firm

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kj, whose financial status is just at the average level, but still better than (or at least the same as) that ofthe reference firm k-i, whose financial status is already bad somewhat.

At this time, we can assume that the firm needed to be appraised operates very bad, and is vulnerable to financial distress. Its financial status is worse than (or at best the same as) that of the reference firm k^, whose financial status is already bad somewhat, though is still better than (or at least the same as) that of the reference firm ^^4, who is already in financial distress.

In this worst case, we can infer that the firm needed to be appraised is in financial distress, and what is even worse is that its financial status is no better than that of the reference firm k^, who is already in financial distress. In practice, in order to get more precise appraisement, we often take the real value, but not just the priority, ofthe grade of target center ofthe firm needed to be appraised Yoj into consideration. Take the case of 2 as an example, if y < / < y we often

allow for the closure of yoj to y^^ and y^^^^ respectively. Moreover, in some circumstances, more reference firms may be needed in order to get more precise appraisement.

Numerical Example
Variables and data
Table 1. Raw data. I, 1 2 3* 4 0.01 0.15 0.07* 0.15
I2 I3 I4

0.01 0.05 0.00* 0.09

-0.16 0.17 -4.22* 0.15

0.46 0.52 0.26* 1.04

0,24 0.58 0.12* 0.46 To be continued

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Table 1. Continued. Indexes -V. Companies I, 0.10 0.13 0.16* 0.12 0.13* I2 I3 I4 , Is

5 6 7* 8 9* 10 11* 12

0.09 0.07 0.13* 0.03 0.09* 0.11 0.12* 0.01

0.18 0.19 0.24* 0.11 0.23* 0.54 0.41* -0.84

0.86 0.58 0.62* 0.54 0.76* 1.26 0.87* 0.38

0.34 0.48 0.54* 0.32 0.68* 1.02 0.66* 0.18

0.19 0.18* 0.00

Data sources: httD://ww\v..sse.com.cn. The data added by * represent those of the reference firms.

Grey target transformation 1. Constructing standard model coo If POLGJ,(yt)=POL(mqx), let ), let (3) If POLG),(/t)=POL(mem), let cooik)= ^"^coik) or O)o{k)=uo (a given constant), a),{k)e(o(k). Then fi>o=(fi^(l), ^ ( 2 ) , ..., fi^(w), o)o(m+\), ..., o)o{m+n)) is called the standard model. In this example, all indexes have maximum polarity, and thus we get the standard model as 2. Grey target transformation Let xik)=To)i{k), where T denotes the grey target transformation function, here let we get the grey target center Q}o={O.\9, 0.13, 0.54, 1.26,1.02).

For simplicity, here we still assume that the distinguishing coefficient i^=0.5 as in the classical grey theory. Then we get the data after grey target transformation as shown in Table 2.

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Table 2. Data after grey target transformation. Companies I, 1 0.052632 0.789474 0.368421* 0.789474 0.526316 0.684211 0.842105* 0.631579 0.684211* 1 0.947368* 0

h
1 0.076923 0.384615 0* 0.692308 0.692308 0.538462 1* 0.230769 0.692308* 0.846154 0.923077* 0.076923

h
1 -0.2963 0.333333 -7.81481* 0.277778 0.333333 0.351852 0.444444* 0.203704 0.425926* 1 0.759259* -1.55556

I4

I5

0 1 2

1 0.365079 0.412698 0.206349* 0.825397 0.68254 0.460317 0.492063* 0.428571 0.603175* 1 0.690476* 0.301587

1 0.235294 0.568627 0.117647* 0.45098 0.333333 0.470588 0.529412* 0.313725 0.666667* 1 0.647059* 0.176471

3*
4
5 6 7* 8 9* 10 11* 12

Target center coefficients and the grades of target center We get the target center coefficients shows in Table 3.
Table 3. Target center coefficient. 1 1 1 18* 1 1 I 1* 1 1* 1
If-

0.930318 0.975673 0.999949* 0.95701 0.93685 0.961254 0.973695* 0.981655 0.950715* 0.950607 0.952456* 0.333333

0.775971 0.978806 0.478973* 0.982276 0.968542 0.974305 0.970906* 0.983729 0.969063* 1 0.960522* 0.490902

0.737613 0.973892 0.972079* 0.949112 0.937642 0.966649 0.968766* 0.966371 0.956746*

0.813495 0.964378 0.983888* 0.971539 0.968542 0.96593

3*
4 5 6 7* 8 9* 10 11* 12

1*
0.975159 0.95241*

1
0.96397* 0.832596

1
0.966159* 0.894734

The grades of target center: 0.851479 0.97855 0.886978* 0.971987 0.96231 0.973628

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0.982673* 0.981383 0.965787* 0.990121 0.968621* 0.710313 F=0.717 / , + 0.847 h + 3.107/3 -1-0.420/4 -1-0.998/5
k=\

roi = O.117753ro,(l)+O.1391O3ro,(2)+O.51O264ro,(3)+O.O68977ro,{4)+O.1369O2xo, (5) The grades of target center based onAltman coefficient: ;t)i=0.827325, ;'02=0.978161, ro3*=O.729564*, ;'04=0.9768, ^05=0.965705, ;'06=0.973613, 707*=0.97934*, ^'012=0.618689. Results From the calculations above, we have Thus, in the paper, the company 3, company 7, company 9 and company 11 are reference companies, whose financial status has already been well-appraised. Specifically, company 7 operates very well, and its financial status is very good. Company 9 also operates well, but its financial status is worse than that of company 7. The financial status of company 11 is just on the average, while the financial status of company 3 is bad, and vulnerable to financial distress, and so on. According to the respective grades of target center and the revealed information of the reference firms' financial status, we can appraise the financial status of the firms needed to be appraised (i.e. company 1, company 2, company 4, company 5, company 6, company 8, company 10 and company 12) as follows: 1. For yo\o>M>roi*, we can infer that the financial status of company 10 and company 8 are very good, and better than (in the sense of the grade of target center) that of the reference company 7, whose financial status is also very good. 2. For yoi*'>/o2>7o4>7'o6>7o9*< we can conclude that company 2, company 4 and company 6 operate pretty well, and their financial status is better than (in the sense of the grade of target center) that of the reference company 9, whose financial status is somewhat good, but worse than that of the reference company 7, whose financial status is also very good. Furthermore, the financial status of company 2 is better than that of company 4, so is that of company 4 than that of company 6. 3. For yb\\*>ro\>yo3*, it suggests that the financial status of company 1 is worse than that of the reference company 11, whose financial status is just on the average, but better than that of the reference company 3, who is in financial distress. 708=0.982754, Xo9*=O.966574*, jt)io=O.993128, roii*=O.9652O9*,

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4.

For 7o3*>7oi2, we can assume that the fmancial status of company 12 is very bad, and worse than that ofthe reference company 3, who has already been in fmancial distress. Thus it's reasonable to assume that company 12 is or is going to be in fmancial distress.

Conclusions and Discussion

The approach proposed in this paper can not only be used to appraise the firms' fmancial status, but appraising the similar systems. When determining the weights of the respective indexes in the grey target model, we can use not only the so-called Altman coefficients, but any other methods determining the weights. Furthermore, when constructing the indexes system in the grey target model to appraised firms' financial status, it's not necessary to limit us to use the exact same indexes given in the Alman's model either, and we can also introduce other indexes reflecting firms' financial status but have not been took into account in the Altman's model. Last, but not least, for the approach proposed in this paper being based on the grey system theory, where the data is not necessary large sample and typical distribution, thus can be used widely.

References
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