Front. Comput Sci, China 2010, 4(2: 220-236 ot io.1007/811704-010-0s0s-5 Corporate financial distress diagnosis model and application in credit rating for listing firms in China. ‘Ling ZHANG (63)', Edward I, ALTMAN?, Jerome YEN* 1 College of Basiness Administration, Hunan University, Chusgsha 410082, China 2 Salomon Centes, New York University, New York NY 10012, USA 4 Business Schoo, Hong Kong Univeiy of Science and Tecablogy, Hong Koug, Chinas =~ © Higher Education Press and Springer-Vetlag Berlin Heidelberg 2010 Abstract With the enforcement of the removal sysiem for distressed firms and the new Bankruptcy Law in China’s securities market in June 2007, the development of the bankruptcy process for firms in China is expected to create a huge impact, Therefore, identification of potential corporate distress and offering eatly warnings to investors, analysts, and regulators bas become important, There are very distinot differences, in accounting procedures and duality of financial documents, between firms in China and those in the westem world, Therefore, it may not be practical to directly apply those models or methodologies developed elsewhere to support identification of such potential distressed situations. Moreover, localized mod- els are commonly superiot to ones imported from other cenvifonments, Based on the Z-score, we have developed « model called Zcyire Sv0re to support identification of potential distress firms in China. Our four-variable model is similar to the Z-scote fourvariable version, Emerging Market Scoring Model, developed in 1995. We'found that our ‘model was robust with a high accuracy. Our model has forecasting range of up to three years with 80 percent accuracy for those firms categorized as special treatment (ST); ST indicates that they are problematic. fins Applicatioins of our model to determine a Chinese firm’s Credit Rating Equivalent are also’ demonstrated. Keywords financial distress,, discriminant enalysis, credit rating, listing firms Received August 2, 2005; ceopled March 10,2010 Fazal eaying@163.com 1 Introduction Over the past 20 years, China haé achieved great success in its economic development; the anniiel GDP grovth has ‘maintained an average of over ten’ percent since 2000. ‘China has been very attractive for: overseas investment and been No. 1 in foreign curteiicy resérves since 2006, Such wonderful achieveméits-Wwere ot reflected in the performance of the main: Chitiese securities markets, Shanghai and Shenzhen, as their-A-shares plunged over 40 percent from 2001 to 2005, .The matket changed direction in 2005 and the Shanghai Index grew from 998 in June 2005 to over 6124 in 16th. October 2007. What concerns analysts the most is that the market was perhaps immational and fimdamental anilysis has become useless, Basically, too much liquidity chasing very few good stocks has pushed the market up beyond its value. ‘The fundamentals of firms might not be totally reflected inthei stock prices. For example, the stock prices of some troubled firms that were marked as Special Treatment (ST, which indicated that they had experienced josses ia the past {wo years, increased significantly “in” certain periods. Models to identify potentially distressed firms are very important, Investment strategies of the majority of institutional investors in China favor long-term holding, which might cover soveral yeats. Therefore, it is extremely important to have a sound and reliable model to predict the survivebilty of firms over longer horizons, ver the past fen years, researchers from both from within Chins and without have attempted to develop distress prediction models for Chivese firms. Many of such studies are summarized in the Literature Review inLing ZHANG et al. Corporate financial distress diagnosis model and appeation mi Section 2. However, we found that the different culture's accounting rules may affect the decurmey of the model ‘The first probiem is the differences between accounting procedures. Some researchers’ selected financial and non financial variables based on thei prior studies that wore conducted in developed countries outside of China However, the situations in the country of study were duite “different fom those in China, in particular the accounting rules, equity structure, and the factors that affect the performance of firms. Such models might not be ‘accurate in that they could not reflect the true nature of ‘Chinese firms, unless the data was careflly constructed. ‘The second point is that most of the prior studies on ‘Chinese firms do not havo large samples for validation testing, or they follow-up predictive studies, since data on Chinese firms is limited, especially on distressed firms. ‘This has becn a major challenge to researchers who wanted to study distress or bankruptey prediction of Chinese’ firms. Unlike Moody's or Standart: & Poot’s databases, which have tens of thousands of healthy end “unhealthy firms over tho past 30 years. ‘To overcome the above weaknesses, we focus on the following objectives: +: () To use the variables that try reflect the special condition of China’s accounting procedure, corporate governance, and the unique structure of equity compo- nents of Chinese share-holding companies, (2) Answer the question “Can financial distress cases in China be predicted by the published financial informatior ‘under current accounting. procedure and quality of date"? @) To test the accuracy and robustness of our model on Chinese firms. (4) To provide insightful views of the financiat risks in China’s stock market..-We would like to provide staieholders a'usoful analytical tool to classify and predict financial distress and to assess performance of firms. (5) To see if such model could be used by goverment rogulators, such as China's Securities Regulatory’ Com- mission (CSR), as a thermometer in measuring the financial health condition of each sector and of individal firms Section two provides review of current literature concerning distress prediction research. Section three provides a discussion about the development ofthe Zeina score model and a two-stage validation test, Section four provides the application of Zcaina Score model in credit rating for Chinese listing firms on a large population. Section five summarizés the conclusions and provides some discussion for future research, : 2 Literature review 2A Prior research in developed countries ‘The development of empirical models that discriminate between failing firms from the surviving entities started in tho mid 1960s, The pioneering research included Beaver and Altman's works in business fulure classification by the use of the univariate and multivariate diseciminant analysis (1,2]. The essence of the latter technique is an fiseue of classification under several assumptions. Tt assigns a score, the Z score, to each of the observed fiems, The Z score is a linear combination of several independent variables and 2 cutoff score is estimated 10 ivido the firms into healthy and unhealthy ones. The general MDA (multivariate discriminant analysis) foom is expressed as : 220+ Ake a i where, Z is the score used to classify the objects, cris a constant term, fj aro the discriminant coefficients or weights, f is the time period, and Xj, are discriminant variables, Since then, extensive research has been conducted to evatnate the usefulness of different financial ratios for constructing the discriminant and related models, Over the past four decades, more sophisticated methodologies have bbeen developed to support corporate failure assessment, ‘which included gambler’s rain, option pricing, hazard, neural nefworks, ag well as the application of, other statistical techniques, such as logit analysis, to the failure prediction problem. Such approeches were developed ‘with a strong theoretical foundation on “How a firm goes bankrupt when the market (liquidation) value ofits assets falls below its’ debt obligations or liabilities.” Such structural models were developed and modified by Wilcox and Merton [3,4]. The commercial usage of such an approach includes the famous KMV model now part of | Moody's [5] Four categorics onthe basis of investing estes and ownerckipy state shares (non-tradsle), legal pereon shares (o0-rodable,iatersVerpoyee holdings nd publiiadviual shares. About more than half percent sexe ace not tadable in Chinese Stock Bchages,202 Front Comput. Sei China 2010, 42}: 220-236 A second group of models include those that seek to compute implied probabilities of default (PD), ftom the term structure of yield spreads between default free and risky corporate securities, These are known as reduced- form models, a good example may be found in Ref. [6] A third class of models is comprised of capital market based models, which include the mortality rate model of Altman [7] and the aging approach of Asquith, Mullins and Wolff [8]. ‘The latest ‘approaches include the application of neural networks to support tisk classifica- tion. Despite the variety of approaches used” in failure prediction, statistical methods, like discriminant analysis, still dominate due to their simplicity and accuracy, and romain as the roainstream of the descriptive schoo! of thoughts? see Matthias Kerling’s paper [9]. In general, these models have been associated with high clessfication accuracy, low cost, time saving, as well as convenience in application in solving real world problems. The meth- odologies mentioned above have been replicated and improved to support failure prediction around the, world, for more see Altman and Narayanan [9]. Financial distress has been oxamined by many researchers, Guthmann and Dougall [10] defined three stages of financial difficulty: temporary or technical insolvency, unsupportable debt burden and reorgeniza- tion. In Ref. [10} Dewing identified four causes of ‘business failures: excessive competition, unprofitable expansion, cessation of public demand for the firm's products or services, and excessive payment of capital charges. Beaver [1] defined faifure es bankruptcy, bond default, an overdrawn of bank account, or nonpayment of| a dividend on preferred stock. Altman [2] defined failure as a company that had filed a bankrupicy petition under Chapter X of the Bankruptey Act of 1938 [11]. Donaldson treated failure as low “financial flexibility” [12]. Newton perceived that fiems in financial distress passed through four stages of deterioration before declaring bankruptey: incubation, cash shortage, financial insolvency and total insolvency (13]. ‘The following describe more modem concepts of distress. Tau defined financial distress as a three stage process: incubation, deficit fimds-flow, and financial distross or recovery [13]. Gilbort, Menon, and Schwartz defined distress firms as firms that declared bankruptcy and firms that had negative cumulative earnings over three consecutive years [14], Ross Stephen, A Westerfeld and Jaffe stated that “Financial distress is a situation where a finn’s operating cash flows are not sufficient to satisfy current obligations and the firm is forced to take corrective action” [15]. It is difficult to define precisely what distress or bbankruptoy is due to the variety of accounting procedures or rules in different countries at different times, as well as various events that sent the firms into financial distress However, for most studies conducted in US, they used the criterion that firms filed for protection under either Chapter X of the Bankruptcy Act of 1898 or Chapter 11 of the 1978 Bankruptcy code [2]. Also, most researchers use the contents of financial statements the prediction ‘model to discriminate between failed firms and those that are financially healthy, 22. Research in Chine Research on financial distress and bankruptey prediction Jn China began in 1999. However, the concept of financial distress for Chinese firms is 2 little different from that defined by the westem. world. ‘Therefore, a discussion about the criterion that defines Chinese firms as being in a state of financial distress follows. ‘The new Bankruptcy Law came into effect on Sune 1, 2007, which is applicable to all types of enterprises. However, no fisted firm so far has filed for bankruptcy. Delisted distressed firms are moved tothe “third board” in Chenzhen and trade once & week. The major reason is to strike a balance between the level that society can afford to Jot companies go bankrupt and the degree to which it can develop a social security system fo avoid huge social problems. The reason behind the continuation of these disttessed enterprises is that many of such firms are the ‘backbone of their particular industry, The top priority of such firms may iot be profit making, but merely to keep workers employed. Yet, in some industries the situation simply deteriorated. For example, mary export trading firms using others’ brand name exhibit a deteriorating financial trend that is difficult to recover from. In ondet to protect the interests of investors and as @ ‘warning, from the government, that they should be aware of the risk of default, China's Securities Regulatory Commission (CSRC) decided in March, 1998 to differ- entiate those fitms in financial difficulties by launching a 1) For example, Altman (2), and Altman, Haldeman aod Narayanan [25). These and other modes ar reviewed in Altman and Hotchkiss (26)Ling ZHANG et al. Corporate financial datess diagnosis model and application 203 new policy to offer special treatment ” (ST) to such firms, ‘These ST firms include: (1) Companies that have had negative cumulative ‘earnings over two consecutive years or net asset value (NAV) per share below par value (book value). (2) Companies that have had negative earnings for one year, but the current year shareholders’ equities are below its registered capital.” G3) Companies that have tecsived the auditors’ opinion that the company’s status as a going concem is in doubt. ‘The ST firms are pressed to improve their financial situation by efforts such as reorganization, mergers, Those that exhibit no sign. of financial improvement in the following year will receive a particular transfer warning (P7) from the CSRC. If the PT fimas ate sill unable t revitalize inthe following year, their sharés will be deleted from the stock exchange ~ the action of delisting. In this regard, we define these ST and PT companies as firms in financial distress. The symptoms of Chinese ST and PT firms are very close as to what was perceived earlier by Newton [12], by Lau (13) and by Gilbert, Meno and Schwartz [14], These ST:or PT firms in general will go through one or inore &f four stages: omit or reduce the annual dividend payments due to cash shortage; default on Joan payments leading to a law suit; reorganization or take cover; or deleted from the stock exchange and transferred to Asset Management Companies” for disposal. ‘Many Chinese researchers have studied the corporate financial distress classification problem, Qing Chen was ‘ho firs to use the financial data of 27 ST and non-ST firms to construct a MDA ‘model with an overall predictive accuracy of 92.6 percent [16}. But this study did not include @ holdout sample for test purposes and wes not relevant to the current énvironment in China, Xiao Chen ‘and Zbihong Chen established ‘2 logit model with an overall predictive accuracy of 86.5 percent [17]. Ling Zhang developed a 4-variable discriminant model out of 11 ratios and found it had a predictive ability of up to four years prior to ST [18]. Shilong Wu and Xiatyi Lu ‘conducted a study by-ising 4 linear probability model (LPM), Logistic and MDA; ‘the results indicated predictive ecouracy of 72 percent four years prior to ST [19]. Shiuhua Jiang constnicied a 13 variable logistic model which bas a prediction accuracy of 84.52% two years in advance and 100% one year in advance [20}..ing Zhang, Sou Yang performed a study using Artificial ‘Neural Networks (ANN) which provided good results, with accuracy above 70% {21,22}. JianguorChen et al. used four altemative prediction models to examine the usefulness of financial ratios in predicting business failure in China, and the accuracy achieved 78% two years in advance and 93% one year in advance{23). Zhongsheng. Hua etal, doveloped an integrated binary discriminant rale (IBDR) to modify the support vector machine (SVM) model for corporate financial distress prediction and found its results were betier than the conventional SVM model. ‘The works above formed a base to support further studies of Chinese finns (24), 3° Zonma Score model construction 3.1. Theoretical foundation of Zscore Credit risk evaluation originated fiom the analysis of financial status change of firms, since credit erisis is usually caused by financial issues like cash flow reduction, ‘Through the discovery of characteristic finan~ cial indicators, itis possible to identify potential distress. Such financial indicators can be used to develop credit scoring or credit rating models to predict or determine the credit ratings of firms. The credit rating is the foundation for pricing credit loans and decision making for invest- ments. Based on such motivation, researchers usually fumed the measurement of credit risk into the evaluation of corporate financial health, ‘Altman [2] used a linear discriminant analysis method to study credit risk measurement and developed @ now famous five-variable Z-score model. This model was ‘generated from analysis of 22 financial ratios through a statistical filet that was based on a sample that ednsisted of 33 distressed and 33 noi-distressed companies daring the period 1946 to 1965. in 1977, Altman (25] improved ‘upon this model and developed the Zeta discriminant ‘model which is sill in frequent use today. Since its inception, and especially in the last decade, the Z-score ‘models have been extensively applied to corporate eredit risk measurement and ratings equivalent, inchiding for firms in the emerging market. Under Altman’s influential he sare capital inially coated in aceordance with he Artes of Associaton 3) 3a 199 the Chinese goveinment setup fowracet management companies to purcose and deal wit hte noo-perfoming fans orbad debs transfered by sta banks. The four exporatons ince: Chins Greavall Axel Management Cop, Chioa Orient Asset Mavggemeat Cop, Chisa Huarong Asset ‘Management Crp 84 China Cinds Asset Management204 Pront. Compat. Sci. China 2010, 42: 220-236 work, many finaucial institutions in the developed countries, such a5, Japan, Germany, France, England, Australia and Canada, have developed their own dis- criminant models. The Altman Z-scoré model is now available on Bloomberg terminals throughout the wortd, Multivariate discriminant analysis (MDA) attempts to lassity objects into categories like financially healthy or ‘bad firms. This technique identified a set of factors which offted enhanced information about the subjects from a set of variables, such as finsncial rntios, which indicated: a umber of characteristics of the observed objects, such as ‘the possibility of distress. This set of variables éan be used to establish the discriminant function which minimizes the probability of false judgment in sample classification. A general form of discriminant fanetion is expressed earlier in Bg. (2). Fisher believed that in order to enable the Z-score to classify two different populations most effectively, the isctiminant coefficient must estimate the standard deviation sum of squares B of B(Z) between two populations relative to the variance of Z-scote as large as possible: 3 mx @) where WY is the variance of @ population and B= [PZ)-E@)P; BL COARYB= Bi ob 1S aos 2 ° 05-09 u 1 03.05 s st @~30) ‘st companixn 21) SL ° 05-08 L ° 03-05 2 1 : os 5 » <00 3 ‘Total sample N= 60 “Teta ample = 6 0 (2) Firms with Zcpiga-scores over 0.5 and less than 0.9 (05 1 270 o ° 5 si 5 218 2 sal due to several reasons, including, SARS, and subse- quontly 15 firms rated BBB and A disappeared in 2004. “The percentages of those classified at a D level are 2,70% {in 2002, 13.51% in 2004, 21.62% in 2006, and 5.41% in 2006, which likely indicates that 2004 and 2005 were tough years for Chinese firms. Companies that fell below the BBB grade should warrant more attention from regulators and stricter ‘monitoring. Based on the past experience, firms may ‘oven suffer ST announcement or even delisting if the operation of such companies is not improved. For such reason, when the rating. gets close to BBB, listed companies should take action to improve or even change ‘management in order to manage a finascia! turnaround. ‘Therefore, the results indicate that our model can be used to help investors forecast which firms might be in trouble in the future and fo avoid making poor investment decisions, 5 Conclusions In this paper, we first constructed Zein score model and applied this model on a large number of listed firms in credit rating based on theit Zehins core, the data sots come from Shenzhen GuoTaiAn Information Technology and ‘Tinysoft Finance Analysis Database [28] covering the , period from 1998 to 2008. Our model is able to identity the potential distress of Chinese companies with satisfac tory accuracy of 70% three years in advance. Our model is very similar to that of the four-variable version of the Z- ‘Score emerging market model. One of the four variables (WCYTAY), is identical and three (NP/ATA), (RE/NP) and (TL/TA) are close variations on the three that were used in ‘the catlier model, ‘With the enforcement ofthe removal system for distress firms and the Bankruploy Taw in China's secuitios ‘market in June 2007, the development of the bankruptcy process for firms in China is expected to create a huge impact. This model can play important role in identifica- tion of potential corporate distress and offering carly ‘warnings to investors, analysts, and regulators. Kolmogorov-Smimov test is a gooklness-oFfit test which examines whether the sample set is subject to designated theory distribution. Posit that F(x) is a good estimation of the uaknown population distribution function ), and select test statistic Z~ max [F,(2) ~Fo(®)]- Ifthe sample is subject to the designated distribution, i.e, FG) = Fo(s), the observed value of Z should be small, otherwise, the mull hypothesis could be false. Our study tests whether the sample is subject to a normal distribution, See Table A.1 for test resus. Sin the test, Z-values of Xo, Xay Xo Xo Xin Nias Xie and Xjs are all small with significance level over 5 percent, ‘which is basically in accordance with @ normal disteibu- tion, The Z values of other indicators it Xi, Xs X35 Xp %y, Xo and Xj, are large with significance level mostly at 0.000, rejecting the null hypothesis of complying with the normal distribution hypothesis. ‘We tested the following hypotheses on the 15 vatiables: He: The mean of X; in group 0 is equal to that of % in group 1, ‘Hy: The mean of Xin group 0 is not equal to that of in sroup 1, ‘where group 0 is the ST group and group 1 is the non-ST group. “The tost statistics are Wilks’ and F statistic, Wilks’ statistic is sometimes called UT statistic. For two groups, ‘when variables are considered separately, 2 is the atio of the sum of squares within tho groups to the total sum of squares:Ling ZTIANG etal. Conorate financial 5, _ Stim of squares within groups _ SSW re Total sum ‘of squares SST? © where S99 = S095 (oe HY 1, is the sample size of group i. Ifthe means of elf observation groups are the same, 2is| equal to 1. A large 2 indicates the means of the different groups are similar whilst i small 2 indicates the means differ more greatly: For the test of equal inieans between two samples, F statistic value is ss sae ° si ~ SSW ® n= where SSB =) “n,(;-3)". ot If the significance level is too low, the null hypothesis thatthe means ofall groups ate equal will be rejected. See Table A. for test results “The test results indicate that Xe, XX, Xo, Xin and Xs reject the null hypothesis thatthe sample means between group | and group 2 aie equal at significance level a= 0.01, which indicates, that there exists significant ‘Table BA _Conclaton matric istess diagnosis mode! and application 235 Table A.A Test result for equal sample mean Varnes Wile"? uaiate - DRY DE) Sigaiisnos x om wa 8 O92 we 09 0 38 asa %& 0966 30 ase % ost 2367 0D % os os 8 ose % osm aa 38 a0 % 02a 39d 8 ao % am 4385 st 0.000 % ams gL 8 on00 Zio as9 oo 08s iu om 5785 8 ome Ma ono ak 80000 os 5952 8 ols as 4s 38 oom os oar 589002 differences in these indicators between financial distress companies and non-distress companies. While the 2 values of Xi, Xa, Xs, Xiy Xs) Xtop Xius Xis and Xig ate relatively large, indicating that the means of these indicators between financial distress companies and non- ress companies are not statistically different, Appendix 8 Correlation matrix of 15 variables shown in Table B.A ‘From the correlation matrix we found that many indicators did not have strong correlations among each other; except Sg eis Re a RT AO Tomas 0017 tos? ons —onse air asco oan aed 007s —aons bani 00s nie % 125 1000-086 678 -0m0 az gam 0105 0417 0479, 0196 dom oes 002s do%s % 0017 noo” uic0""do12 “ons om aos eo void “asss' 0030 ass —n06s -0097 008" % vote 0073 002 000-0303 038-0138 -0100 0058 -o4l8 0307 a1 0423" @150 0408 % 0086 -0m00 863 “0303-109 -n529 ase "O68 a408~ OAD 0A O08 0149 -a0s4 0000 % 0056 0123 +00 0385 0529 19m avs -0126 010 0537 0257-0285 am? 0095 O16) % 0980 0405 9550 —0100 O08 -n125 am tomo 085 e472 aH O48 —0m27 -ao12 060s % 0073 8186-0050 9307 —017O 2257 -no#H OOM aoK ~C235 100 a0 ome 028 aD % 0851 0117 OOM 198 0105 0102 noms aay 100 0138 OOM a9s ~Aom esas 0087 Mo 006-0173 009 ~Oit “04 0597 aao7 aim aise 000 0283 0137 nos -n.10 0006 My Quo e024 0050 01980135 040i 1000 aoe GoB6 4207 008, -n202 a6 ~00% + 0088 Ya 0078 -0C09 0955 0122 0408-4225 nam O11 04S 0437 aA Lom 00 eoIT a0Rs %ig 0021 0088 0088 0125 0149 9072 040s ~no27 0053 —n00s 00m -no1s 1000 0294 oo7l Yq 0016 0025-2097, 150 —0054 202s core oo12 ome 0110 0298 B07 0294 1000 eam %is_0066 0045 008" 0109 o000 0161 ose aos 0047 aos 0100 R006 eon 02K L000236 ‘Front: Comput. 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