ZSCORE

ANALYSING POTENTIAL BANKRUPTCY THREAT USING ALTMAN Z- SCORE:

STUDY OF RANDOMLY SELECTED BORROWERS FROM PSU BANKS

AVIJIT SINGH – EPGP -11-020

ADITYA TANEJA – EPGP -11-006

HARSHDEEP S DUA – EPGP -11-044

PREETI SINGH – EPGP -11-082

SARIKA TALWAR – EPGP-11-105

INTRODUCTION

The menace of NPA (Non-Performing Assets) in banks has taken a very serious turn with a group of 12
lenders put under PCA (Prompt Corrective Action) by Reserve Bank of India for high level of bad assets
and negative returns on assets. As per RBI estimates the gross NPA’s in Indian banks, specifically in public
sector banks, are valued at ₹ 4,00,000 Crores which accounts for approximately 90% of the total NPA’s
in India.

INDIA NON-PERFORMING LOANS TO TOTAL GROSS LOANS (%)

10.85 10.79
10.34
9.85 9.73 9.98
8.80 9.19 8.95
7.39 7.57
5.88
4.77
4.35 4.23 4.61
3.75 3.95 4.13

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
2014 2014 2014 2014 2015 2015 2015 2015 2016 2016 2016 2016 2017 2017 2017 2017 2018 2018 2018

Data Source: IMF

This despite the fact that assets were assigned investment grade ratings by external credit rating
agencies, which shows that the same has not been an accurate predictor of potential risk of bankruptcy.
It is also observed that in majority of recent corporate bankruptcies, there was a steep decline in ratings
from investment grade to junk grade in a short span of time. This has led to some serious questions being
raised with respect to bankruptcy prediction models. There are several models that can be used to
analyse the financial health of a company by using the financial ratios the most notable being the ALTMAN
Z-SCORE.

ALTMAN Z-SCORE

In analysing the financial health of a company, ratio analysis is needed through financial statements.
Investors and owners usually use financial ratio analysis to learn more about the detailed analysis of
company’s financial health as well as its potential. Financial ratio analysis can also be used in two
different ways, but same usefulness.

First, financial ratio analysis can be used to examine the performance of a company in comparison to past
periods of time.

Second, the investors or owners can use the ratio analysis to compare the performance of a company
against that of its competitors or other members of the industry.

There are several models that can be used to analyse the financial health of a company by using the
financial ratios. Altman’s Z-score model uses the Multiple Discriminant Analysis (MDA) method which in
its calculations uses financial ratios.

We have adopted the Altman Z-Score of 1968, which has the following formulation:

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 Z-SCORE = 3.25 + 6.56 X1 + 3.26 X2 + 6.72 X3 + 1.05 X4

X1 = Working Capital/Total Assets

X2 = Retained Earnings/Total Assets

X3 = Earnings Before Interest and Tax (EBIT)/ Total Assets

X4 = Market Capitalization/Total Liabilities

X5 = Sales/Total Assets

OBJECTIVE:

The objective of this study is to analyse the relationship between the financial health of the company as
predicted by the ALTMAN Z SCORE and the performance of the company as measured by the RETURN
ON EQUITY. We have used linear regression to analyse the magnitude and direction of the relationship
between these two variables.

Inspiration for this study was taken from a seminar attended by the team on “INDIA CREDIT RISK
SUMMIT” where the keynote speaker Professor Edward Altman, Professor Emeritus of Finance at NYU,
Stern School of Business, best known for the development of Altman Z-Score for predicting bankruptcy
shared his insight based on 50 years of his work on Credit Risk Management and what went behind
formulating the Z-Score which is a Multi Linear Regression Model (MLR) on the basis of his rich
experience of study of manufacturing and non-manufacturing industries across various economies in the
world.

He expressed his concerns on the credibility of external credit rating agencies in India which tend to be
lenient in assigning prime ratings to many of the emerging corporates which do not have a significant
past financial track record and access the markets to raise capital. During our discussions it transpired
that presently PSU banks are in the need for devising statistical and analytical tools which will better help
them in better predicting bankruptcies so that the credit risk management setup could be made more
robust.

RESEARCH QUESTION AND HYPOTHESIS:

The research question for this assignment is whether higher performing companies (listed) also exhibit
higher financial health as predicted by ALTMAN Z SCORE values?

Ho : No significant relationship between firms performance and financial health

Ha : Significant relationship between firms performance and financial health

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DATA SOURCE:

 The Financial Information of borrowers from varied sectors operating in diverse geographical
locations maintaining accounts at State Bank of India(SBI) and Central Bank of India(CBI) have
been randomly chosen from their existing portfolios to have a decent sample size.
 Inputs from the presentation of Professor Edward Altman have been incorporated and taken as
basis for conducting the study.

METHODOLOGY:

We have run a linear regression model using the data collected with the formula:

𝑌 = 𝛽1𝑍1 + 𝐶
Y = Dependent Variable i.e. Return on Equity (R.O.E)

B1 = regression coefficient,

Z1 = Independent variable i.e. Z score

C = Constant

DESCRIPTIVE ANALYSIS:

As shown in Table 1 below, Mean Z-score for the sample set is 3.70 with Median of 1.54

FY 17-18 MEAN STANDARD ERROR MEDIAN

Z SCORE 3.709924029 1.072079839 1.54631251
Table 1: Mean and Median Z-Scores

As per Altman (1968), following benchmark is provided:

DISTRESSED ZONE: Z< 1.80 ZONES OF

GREY ZONE: 1.80<Z<2.99

SAFE ZONE: Z>2.99

DISCRIMINATION

The mean Z-Score of the sample set is in the healthy range, whereas the Median Z score is in the lower
range indicating that significant assets are in distress.

The Median Z score is significantly lower than the Mean Z score indicating the variation in the size of the
companies in the sample set.

Mean Z-Score of 3.70 indicates the strong financial health of the sample set in the market.

# Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Z SCORE 0.027473091 0.005815479 4.724132203 0.000229237 0.015144827 0.039801356

Table 2: Regression Output

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 Regression Statistics
Multiple R 0.763174559
R Square 0.582435407
Adjusted R Square 0.55633762
Standard Error 0.109061968
Observations 18
Table 3: Regression Statistic

As provided in Table 2, regression coefficient is 0.027 (rounded-off) with a Standard Error of 0.005
(almost equal to zero) and t-statistic of 4.72 at 95% level of confidence is statistically significant. These
values support the reliability of the regression output.

t-statistic of 4.67, result confirms the rejection of the null hypothesis and thus we can confirm that there
is a strong positive relationship between Return on Equity (Dependent Variable) and Altman Z Score
(Independent Variable).

There is a strong positive correlation of 0.763 (76.3%) between ROE and Z score which further affirms
the strong positive relationship between the two parameters.

LIMITATIONS

Limitation for the exercise is the small sample size of n=18 companies. Increasing the sample size would
further improve the adjusted R sq. measurement of 55% and let us provide a much better forecast
regarding the financial health of the current portfolios in the banking system.

CONCLUSION:

The PSU Bank’s loan portfolios have added a lot of toxic assets over the last decade which reflects in their
distressed financial standings as on day.

The PSU Banks in India have witnessed a back to back spurt in their asset books as well as NPAs in a very
short interval of time which clearly highlights the deficiencies of effective quantitative tools/methods in
managing the credit risk.

The Bank’s as a result of their reckless financing have created a pool of bankruptcy datasets for analysis
to be done by the credit risk analytics professionals.

At present the bank rely on their Internal Rating Based approach scoring models as well as the External
Credit Ratings assigned by a few RBI approved agencies. It may be very well observed that all these
existing tools and credit risk evaluation methods lack a predictive element. The present day BASEL-II
norms mandate the banks to provide capital for losses based on the Loss-Given Default as well as
Probability of Default attuned to Risk weightages.

Going ahead with the Banks facing a daunting challenge to be compliant with the newly introduced
BASEL-III norms which mandate for providing regulatory capital toward the expected losses on
account of probabilities of default in assets , need is felt to suggest more robust quantitative models and
calculators which can help the banks predict bankruptcy much in advance and plan timely exits/sell-offs
or provision coverage planning . At present , while appraising individual variables are computed and
compared against the accepted benchmarks/financial covenants . Off-late Banks have also introduced the
concept of RAROC – Risk Adjusted Return of Capital which is a function of income, security coverage and
external rating . The Banks are facing it challenging to scan a population of data sets comprising of loan

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assets of various companies belonging to varied sectors and operating in dynamically changing business
environments.

We have tried to analyse a sample of randomly chosen borrowers with outstanding debts with the PSU
banks using a Z-Score which is a time-tested methodology originated in the US. Given the nascent stage
of Financial Markets in India and lack of secondary markets to trade securities and assets, we wanted to
ascertain the relationship between the model which predicts the financial health(Bankruptcy Predictor)
and financial performance of the companies which is broadly seen through Return on Equity.

The Statistical results conducted on a sample size of 18 borrowers(financial metrics annexed herewith)
which also happen to be listed companies having a market valuation of their equity reveal that there is a
strong relationship between the Return on Equity and Firm Performance for the companies listed on the
Stock Exchange. Thus for equity as well as debt investors analysis in terms of Z Score alongside ROE can
prove to be a game changer/important tool for analysing the health of the company while making the
right kinds of decisions and avoiding Type-II Error.

Further we strongly feel that by collecting as many samples as possible, computing the sample statistics
and applying the Central Limit Theorem, each bank can set their own reasonable benchmark Z-Score that
is the (Mu of the Population) as a part of their credit risk management policy to better predict the health
of their portfolios

These Business Data Analytics tools have been making well calibrated fresh disruptions which has
resulted in Fintech and AI taking on Front Office in the Banking Space and to respond to this rising tide
of technology, we would be requiring more skilled and equipped professionals who can perform much
better in the prevailing multi-dimensional market conditions.

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 DATA 2017-18 (ALL FIGURES IN ₹ CRORES)
MARKET TOTAL
CURRENT CURRENT TOTAL RETAINED Z-
# COMPANY EBIT VALUE OF LIABILIT SALES X1 X2 X3 X4 X5 ROE
ASSETS LIABILITY ASSETS EARNING SCORE
EQUITY Y
BAJAJ
1 HINDUSTAN 5,917.06 4,502.79 14,592.66 -423.19 252.87 153.95 11,241.34 6,009.32 0.10 -0.03 0.02 0.01 0.41 0.55 -0.13
SUGAR LTD
DIXON
2 TECHNOLOGIES I 472.42 366.10 635.94 57.61 95.51 2,519.32 382.13 2,213.60 0.17 0.09 0.15 6.59 3.48 8.26 0.23
LTD
3 SEVEN SEAS 11.57 135.49 413.58 5.39 44.99 112.13 344.37 123.08 -0.30 0.01 0.11 0.33 0.30 0.51 0.08
GINNI
4 288.47 310.95 572.92 2.66 32.31 89.02 394.10 708.42 -0.04 0.00 0.06 0.23 1.24 1.52 0.01
FILAMENTS LTD
JET AIRWAYS
5 7,053.45 14,189.25 12,501.23 -767.62 75.24 2,485.51 19,743.23 23,958.37 -0.57 -0.06 0.01 0.13 1.92 1.24 0.11
LTD
MOTHERSUN 19.0
6 2,340.00 1,459.00 8,809.60 879.10 1,254.00 50,084.84 2,629.40 7,596.50 0.10 0.10 0.14 0.86 13.02 0.14
SUMI 5
JUBLIANT
7 1,352.89 1,238.48 4,624.54 263.44 502.86 12,410.39 2,375.16 3,352.54 0.02 0.06 0.11 5.23 0.72 4.33 0.12
LIFESCIENCES
8 INDIA GLYCOLS 1,116.92 1,573.33 3,344.51 98.08 266.15 801.28 2,403.38 4,130.89 -0.14 0.03 0.08 0.33 1.24 1.58 0.10
9 BOMBAY RAYON 5,787.88 3,506.66 9,136.75 -282.07 63.78 285.73 4,846.35 3,108.59 0.25 -0.03 0.01 0.06 0.34 0.66 -0.07
10 ONGC LTD. 21,516.55 49,361.86 2,91,228.18 19,945.26 30,400.94 41,634.39 97,843.50 92,846.63 -0.10 0.07 0.10 0.43 0.32 0.90 0.10
11 RATTAN INDIA 2,036.04 4,474.34 14,448.58 -418.38 578.25 379.61 9,841.20 2,239.49 -0.17 -0.03 0.04 0.04 0.15 0.07 -0.09
12 JSPL 9,711.86 15,588.37 60,076.60 -361.61 1,719.37 15,051.57 37,284.04 17,065.17 -0.10 -0.01 0.03 0.40 0.28 0.49 -0.02
ECE INDUSTRIES
13 156.57 165.04 442.24 56.28 95.50 143.37 167.61 55.20 -0.02 0.13 0.22 0.86 0.12 1.51 0.20
LTD
20.1
14 SHEELA FOAM 489.14 267.19 888.47 342.14 188.26 6,877.89 342.14 1,681.50 0.25 0.39 0.21 1.89 15.49 0.63
0
15 RSWM LTD 1,148.52 1,141.27 2,173.01 14.50 138.00 383.74 1,812.27 2,975.95 0.00 0.01 0.06 0.21 1.37 1.72 0.04
MARAL
16 222.66 271.19 403.31 0.99 19.28 98.80 309.16 653.06 -0.12 0.00 0.05 0.32 1.62 1.83 0.01
OVERSEAS LTD
LAKSHMI
17 MACHINE 1,655.32 736.83 2,553.55 211.42 303.81 6,105.65 831.90 2,667.29 0.36 0.08 0.12 7.34 1.04 6.39 0.12
WORKS
18 HSIL 1,428.04 1,186.28 3,474.91 74.76 168.06 19,191.78 1,985.64 2,259.23 0.07 0.02 0.05 9.67 0.65 6.72 0.05
THANK YOU