This chapter's objectives are two-fold: first, to technically modify Altman's model and formulate Altman's index (AIN) in such a manner that only two out of five stipulated financial ratios would suffice the major purpose of projection of soundness of any business organization's financial health; and second, to formulate a financial performance index (FPI) consisting of five financial ratios treated as independent variables that would help to provide a holistic overview of a firm's performance regardless of its functional domain. Since the much-discussed and strongly valid issue of non-normality is closely associated with the financial ratios in the macroeconomic perspective (group of industries), in order to avoid the underlying controversy, the microeconomic approach is followed considering a single firm, Wal-Mart, primarily for two reasons: first, for its financial soundness and, second, it can be used for a comparative study with a financially bankrupt firm by using the financial ratios as common variables to derive the “specific” condition for bankruptcy.
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Altman (1968) used Multiple Discriminant Analysis (MDA) for bankruptcy prediction of business firms with a specific objective in mind and that was to broadly classify 66 firms in two equal sections of 33 firms each, i.e., one section of 33 firms were classified under Chapter X of the National Bankruptcy Act during the period 1946 - 1965, and the other section consisted of equal number of firms under non-bankruptcy with asset sizes ranging from $1 million to $25 million. This particular technique helped to successfully compare the major underlying difference (in terms of financial ratios) between the bankrupt and non-bankrupt firms. The final discriminant function was expressed as the linear equation below:
where
= Working Capital (WC) to Total Assets (TA) ratio,
= Retained Earnings (RE) to Total Assets (TA) ratio,
= Earnings before Income Taxes (EBITA) to Total Assets (TA) ratio,
= Market Value of Equity (MVE) to Book Value of Debt (BVD) ratio, and
= Net Sales (NS) to Total Assets (TA) ratio.
Clearly, Altman’s Z – Score model was formulated on a macro perspective comprised of five independent variables. Although quite competent in its own merit, Altman’s model requires estimations of five different financial ratios which at times, may be time – consuming and difficult to ‘handle’ in terms of calculations. In this research paper, an attempt has been made to simplify the existing Altman’s model by keeping its basic foundation intact while dealing with the same 5 independent variables simultaneously. Although this study has been done on a single business firm (micro perspective), i.e., Wal-Mart; the regression relationships could be replicated in macro perspective also (for a group of firms).
In order to streamline the existing Altman’s model, the first step was to pick the most common element out of the five ratios regardless of the choice between numerators and denominators. The obvious choice was Total Assets (TA).
Now since TA is the common choice for denominators for 4 out of 5 financial ratios, hence statistically, there remains a probability of some degree of correlation between TA and those 4 numerators, namely., Working Capital (WC), Retained Earnings (RE), Earnings before Income Taxes (EBITA), and Net Sales (NS) respectively (Lev and Sunder, 1979). Keeping in mind the same hypothesis, a probe for correlation between Market Value of Equity (MVE) and Book Value of Debt (BVD) could be conducted for the fourth independent variable. Thus for 4 out of 5 independent variables, i.e., X1, X2, X3, and X5, the common denominator TA is treated as the dependent variable and the remaining 4 numerators WC, RE, EBITA, and NS are treated as independent variables. For the remaining variable X4, the numerator MVE is treated as the dependent variable and BVD is treated as the independent variable. The reasons for choosing TA and MVE as dependent variables are quite straightforward as follows: