Financial Distress Prediction Using Z Score Essay

5279 words - 22 pages

IntroductionAccording to Pate (2002), 257 public companies, with total assets of $256 billion, filed for bankruptcy in 2001. That this is the highest number of bankruptcy filings since 1980 is alarming. Furthermore, it is uncomfortably large compared to the number of filings during the last recession (125 filings in 1991 and 91 filings in 1992). Pate further estimates the likely number of public company bankruptcy filings in 2002 will be about 200, 22 percent below the 2001 level, but still well above the 1986-2000 average of 113. Another clearly visible trend is the increase in the number of large companies going bankrupt. Altman (2000) points out that bankruptcy in firms with large asset ...view middle of the document...

Dealing with insolvent estates for legal procedures dates back to ancient Roman law. The principles of insolvency got extensive codification during the middle ages, and then the study of insolvency prediction evolved. Smith and Winakor did the first study in 1935, during the Great Depression era, then in 1942, Merwin showed that failing firms exhibit significantly different ratios than do successful firms (Sung et al., 1999:65).The social and economic costs associated with insolvency need a law to govern the whole process. The South African Law Commission (2000:10) referring to the Legal Department of International Monetary Fund, stated that the overall objective of insolvency laws are (1) the allocation of risk among participants in a market economy in a predictable, equitable, and transparent manner; and (2) to protect and maximize value for the benefit of all interested parties and the economy in general (chapter 2 of the document which is available on-line at: www.imf.org/external/pubs/ft/orderly/index.html).In the case of forced bankruptcy, which is initiated by creditors, the process require the involvement of the civil authorities in the settlement of the credits. Schwartz (1996:26) summarizes that bankruptcy law enables the right of the creditors to collect, guarantee ratable distribution of asset value among creditors according to contractual priorities, and provide debt restructuring possibilities.In South Africa the term insolvency is used rather than bankruptcy. Insolvency is company failure with firms undergoing a formal liquidation procedure upon classification as failed (Truter, 1996:2). The Insolvency Act 24 of 1936 of South Africa is the replacement of the Insolvency Act 32 of 1916. During 1996 a draft insolvency Bill and Explanatory Memorandum was published as Discussion Paper 66, and in 1999 a further draft Insolvency Bill and Explanatory Memorandum was published as Discussion Paper 66 and 86 (South African Law Commission, 2000:9). These amendments were important in the modernization of the law of insolvency.Recent history of bankruptcyThere is an increased attention in bankruptcy and other forms of business failure in recent years. It is continued to be a topic of interest to researchers from the field of accounting, economics, and finance. The substantial increase in business failures recently, and the resultant losses for creditors, has promoted a renewed interest in exploring all possible means by which business failures can be predicted in their early stages, thus permitting quick remedial action in an effort to minimize loan losses (Doukas, 1986:479). The increase in the size of liabilities of failed firms and the proportion of large firms that file for bankruptcy has been even more marked. According to Chuvakhin & Gertmenian (available on-line at http://abr.pepperdine.edu/031/bankruptcy) the size of the companies going bankrupt has been a distinct trend of filing for bankruptcy over the past several years. As...

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