Journal of Business Research 54 (2001) 53 61

Tests of the generalizability of Altmans bankruptcy prediction model

John Stephen Gricea,*, Robert W. Ingramb
a

Sorrell College of Business, Troy State University, 131 Bibb Graves, Troy, AL 36082, USA b The University of Alabama, USA

Abstract Though developed in 1968 using a small sample of firms from the 1950s and 1960s, Altmans Z-score model remains a commonly used tool for evaluating the financial health of companies. Because of the age of the model and other attributes, such as its small sample of manufacturing firms and the use of equal group sizes of bankrupt and non-bankrupt firms, it is likely that model is not as effective in classifying firms in more recent studies as it was when it was developed by Altman. This study examines three research questions using recent sample data: (1) Is Altmans original model as useful for predicting bankruptcy in recent periods as it was for the periods in which it was developed and tested by Altman? (2) Is the model as useful for predicting bankruptcy of non-manufacturing firms as it is for predicting bankruptcy of manufacturing firms? (3) Is the model as useful for predicting financial stress conditions other than bankruptcy as it is for predicting bankruptcy? Our results are consistent with negative answers to questions one and two and a positive answer to question three. D 2001 Elsevier Science Inc. All rights reserved.
Keywords: Generalizability; Bankruptcy; Z-score model

Altman (1968) developed his well-known Z-score model using a matched sample of 33 bankrupt and 33 non-bankrupt manufacturing firms from 1946 1965. Though the Z-score model exhibited high accuracy rates using both estimation and hold-out samples (95% and 84%), the generalizability of this model to industries and periods outside of those in the original sample has received little attention. Nevertheless, the original model has been employed in recent research to evaluate financial conditions of firms from a variety of industries and periods (e.g., Chen and Church, 1996; Chen and Wei, 1993; Carcello et al., 1995; Berger et al., 1996; Subramanyan and Wild, 1996). Also, it continues to be used in a variety of business situations involving the prediction of bankruptcy and other financial stress conditions. Commercial banks use the model as part of the periodic loan review process, and investment bankers use the model in security and portfolio analysis. The model has been employed as a management decision tool and as an analysis tool by auditors to assess their clients abilities to continue as going concerns (AICPA, 1987; Dugan and Zavgren, 1988).

The continued use of Altmans bankruptcy prediction model by researchers and practitioners leads to three research questions considered in this paper:1 Is Altmans original model as useful for predicting bankruptcy in recent periods as it was for the periods in which it was developed and tested by Altman? Is the model as useful for predicting bankruptcy of non-manufacturing firms as it is for predicting bankruptcy of manufacturing firms? Is the model as useful for predicting financial stress conditions other than bankruptcy as it is for predicting bankruptcy? Our results lead us to question current uses of Altmans model. Though our results indicate that the model is useful for predicting financial distress conditions other than bankruptcy, they also indicate that the models accuracy is significantly lower in recent periods than that reported in Altmans (1968) study across all sample characteristics considered in this study. Additionally, the magnitude and significance of the models coefficients differ from those reported by Altman. Our results suggest that better accuracy can be achieved by re-estimating
1 Though other models have been proposed and examined in the literature, Altmans continues to be the one most cited and used. See Zavgren (1983) and Jones (1987) for detailed discussions of other models and techniques used in prior bankruptcy prediction studies.

* Corresponding author. Tel.: +1-334-670-3154; fax: +1-334-670-3154. E-mail address: sgrice@trojan.troyst.edu (J.S. Grice).

0148-2963/00/$ see front matter D 2001 Elsevier Science Inc. All rights reserved. PII: S 0 1 4 8 - 2 9 6 3 ( 0 0 ) 0 0 1 2 6 - 0

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model coefficients using estimation samples from periods close to test periods. Also, the accuracy of the model decreases significantly when non-manufacturing firms are included in the sample. Section 1 discusses Altmans model and prior research relevant to this study. Section 2 describes the sample and tests employed to evaluate Altmans model. Section 3 examines findings and Section 4 discusses implications for users of Altmans model.

1. Contributions to prior research This section summarizes Altman (1968) and studies that have examined his bankruptcy prediction model. It explains the contributions of the present study to solving problems identified in these earlier studies. To develop the Z-score model, Altman (1968) compiled a list of 22 financial ratios and classified each into one of five categories (liquidity, profitability, leverage, solvency, and activity). The ratios were not selected on a theoretical basis, but rather, on the basis of their popularity in the literature and Altmans belief about their potential relevancy to bankruptcy. He estimated the model using multiple discriminant analysis to derive a linear combination of variables that discriminated between bankrupt and nonbankrupt firms. After numerous tests, the linear function that best discriminated between the 33 bankrupt and 33 non-bankrupt manufacturing firms was: Z 1:2X1 1:4X2 3:3X3 0:6X4 0:999X5 1

where, X1 is the working capital/total assets, X2 is the retained earnings/total assets, X3 is the earnings before interest and taxes/total assets, X4 is the market value equity/ book value of total debt, X5 is the sales/total assets, and Z is the overall Z-score index. The lower a companys Z-score, the higher its probability of bankruptcy. Scott (1981) noted potential search bias in the variable selection technique used by Altman. The lack of a theory of bankruptcy invites the researcher to consider a multitude of variables and then to reduce the original set to the most accurate subset. The resulting subset of variables often proves ineffective when applied to a sample of firms or periods other than those used in developing the model. Hold-out sample accuracy rates in Altmans and other studies are potentially upwardly biased (Bias here means that the hold-out sample accuracy rates are higher than the rates users should expect when they apply the models) for three reasons: (1) the estimation and hold-out sample periods are not substantially different, (2) the hold-out sample consists of firms from the same restricted set of industries as those in the estimation sample, and (3) the hold-out samples are small (the largest sample was 111 in studies we examined) and are not proportional to actual bankruptcy rates.

Other studies that directly tested the Z-score model include Moyer (1977), Zmijewski (1983), Holmen (1988), and Begley et al. (1996). The most relevant of these to our study is Begley et al. (1996). They applied the Z-score model to a prediction sample that included 65 bankrupt and 1300 non-bankrupt industrial firms from 1980 1989 and reported a 78% accuracy rate. They also re-estimated the Altman (1968) coefficients using a matched sample of 100 bankrupt and 100 non-bankrupt companies. Their re-estimated coefficients exhibited a 78% classification accuracy using their prediction sample. The accuracy rates reported in these studies also are potentially upwardly biased because they suffer from one, or a combination, of the limitations of the hold-out samples described above. For example, all prior tests of the Z-score model used samples that included restricted sets of industries. Also, except for the Begley et al. (1996) study, the results of prior research are dated because the samples were primarily for companies from the 1960s and 1970s. Another limitation of the test samples is that the samples were small and not proportional to actual bankruptcy rates.2 Though Begley et al. (1996) used a proportional sample to test the Z-score model, they imposed a size restriction on firms included in their sample, limiting the study to larger firms. Begley et al. (1996) also used matched samples of bankrupt and non-bankrupt companies to re-estimate their models, thus ignoring the effects of proportionate sampling in developing these models. When a model is applied to periods other than those used to develop and test the model, researchers assume the model is stable across economic conditions that change over time, such as inflation, interest rates, and credit availability.3 The effect of changing economic factors on the accuracy, magnitude, and significance of model coefficients was evaluated by Mensah (1984) who developed four models using samples from the 1972 1973, 1974 1975, 1976 1977, and 1978 1980 periods, each period representing a different economic environment. He reported that the accuracy and structure of the models changed over the four time periods. Accordingly, it is unlikely that Altmans model performs equally well in all financial periods. Tests in the current study compare both the accuracy rates and estimated coefficients of the original Z-score model to those derived using recent proportional samples. Another limitation of the hold-out samples of prior studies is that the samples were small. Altman tested his
Zmijewski (1983) used a proportionate sample; however, he did not report the Z-score models accuracy rate. 3 Begley et al. (1996) also briefly discussed the concerns of using dated bankruptcy prediction models on recent data. They indicated that the merger and takeover activity of the 1980s changed the likelihood of bankruptcy associated with high corporate debt levels. Additionally, they suggested that the changes in the bankruptcy laws during the 1970s allowed companies to strategically use bankruptcy. To the extent the reasons for strategic use are associated with financial variables, models developed prior to the changes in the law may result in greater classification errors.
2

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55

model on two different independent samples consisting of 91 (25 bankrupt and 66 non-bankrupt) and 111 (53 bankrupt and 58 non-bankrupt) firms. Also, the hold-out samples were not proportionately representative of the population of bankrupt and non-bankrupt firms. The average business failure rate is less than 1%,4 while the proportion of bankrupt to non-bankrupt firms included in previous hold-out samples ranges from 24% to 50%. Results of oversampling bankrupt firms include misstatement of Type I and Type II errors. Altman (1968) used an equal number of bankrupt and non-bankrupt companies for his estimation sample. Altman et al. (1977) reported classification accuracy under assumptions of equal prior probabilities as well as under different probabilities.5 The overall accuracy rate (92%) of their model was not affected when prior probabilities more representative of the average business failure rate were incorporated. However, the number of bankrupt (nonbankrupt) firms misclassified increased (decreased) under the more representative prior probabilities. The Z-score model understated Type I errors and overstated Type II errors. Zmijewski (1984) also tested the effect of disproportionate sampling in bankruptcy prediction studies and reported similar findings. Hold-out sample tests in prior studies included firms from the same industries as those in the estimation sample.6 The test samples used in prior studies that directly tested the Z-score model also included restricted sets of industries. Platt and Platt (1991) demonstrated that a bankruptcy prediction model that included industry-relative ratios produced improved prediction accuracy relative to a model that included only unadjusted ratios. Industry-relative ratios were adjusted for the average ratio for a specific industry. Their results suggest that a bankruptcy estimation model developed using firms from one set of industries may not be highly accurate in predicting bankruptcies for firms in other industries. Tests in the current study evaluate results of applying Altmans model to industries other than manufacturing firms. Even though the Z-score model was developed to predict bankruptcy, this event is only one of several indicators (or
The average business failure rate between 1970 and 1991 ranged from .038% to 1.19% (Gentry et al., 1985). 5 Altman et al. (1977) adjusted the models cutoff score to simulate the effect of using unequal prior probabilities. The adjustment factor was calculated as ln( p1/p2) where p1 and p2 represent the prior probabilities of the bankrupt and non-bankrupt groups. If their sample violated the assumptions of equal variance covariance matrices between the groups and multivariate normality, then this adjustment factor may be inappropriate. Though Altman et al. did not report information related to these assumptions, prior research suggests the assumptions are typically violated for the estimation samples used to develop bankruptcy prediction models (Jones, 1987). 6 Altman et al. (1977) used a hold-out sample that included 61 manufacturing and 50 retail firms to test the Z-score model; however, they did not report the models accuracy by industry classification. The model exhibited an 84% classification accuracy for the entire hold-out sample.
4

consequences) of financial distress. It is not clear whether Altmans model is specifically useful for identifying firms that are likely to go bankrupt or whether it is more generally a model for identifying firms experiencing financial distress, though the model is commonly used for this purpose. While firms that experience financial distress are more likely to declare bankruptcy than other firms, most financially distressed firms do not declare bankruptcy. Gilbert et al. (1990) suggested that financial dimensions that distinguish bankrupt from healthy firms are different from those that separate bankrupt from distressed firms. Bankruptcy is a joint result of financial distress and other events that precipitate legal action.7 This study considers the Z-score models ability to assess financial distress conditions other than bankruptcy. If Altmans model is better suited for predicting bankruptcy than for predicting other financial distress problems, it may not be appropriate for some of the applications for which it has been used.

2. Research design This section describes the sample selection criteria. Also, it explains the methodology employed to test the Altman model. 2.1. Sample The analyses in this study used a 1985 1987 estimation sample and a 1988 1991 prediction sample from Compustats annual industrial and research files. 1985 was the first year of the study because certain variables were unavailable prior to this year. The final year in the prediction sample was 1991 because the number of bankrupt firms identified on Compustat was minimal in years following 1991 and we wanted to ensure that sufficient data were available to determine whether a firm declared bankruptcy subsequent to the test period. Distressed companies were defined as those reported by Compustat as meeting one or more of the following conditions: (1) Chapter 11 bankruptcy, (2) Chapter 7 liquidation, (3) bonds vulnerable to default, or (4) low

7 A limitation of the Z-score model is that the variable set does not incorporate proxies for non-financial events that precipitate bankruptcy. For example, a banks refusal to extend credit, lawsuits, and union problems are three factors associated with bankruptcies. Arguably, a banks refusal to extend credit is typically attributable to firms poor financial performances or high debt levels. However, union problems and lawsuits could result in firms filing bankruptcy as a result of strategic management decisions. That is, management may deem it necessary to file bankruptcy to secure a favorable outcome in negotiations or court proceedings, even though the firm is not experiencing serious financial problems. The lack of homogeneity in the motivation for bankruptcy filings complicates the modeling effort, and users should recognize that the Z-score model does not capture all events that may cause, or precede, bankruptcy.

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J.S. Grice, R.W. Ingram / Journal of Business Research 54 (2001) 5361 Table 1 Descriptive statistics for 1985 1987 and 1988 1991 samples 1985 1987 sample Non-distressed (n=824)
a

stock ratings.8 The non-distressed firms were selected randomly from the population of Compustat firms for which S&P ratings were available.9 The 1985 1987 estimation sample included 972 companies (148 distressed and 824 non-distressed). This sample was used to re-estimate coefficients in Eq. (1). The 1988 1991 prediction sample included 1002 companies (148 distressed and 854 non-distressed). This sample was used to evaluate the predictive accuracies of both Altmans original and the re-estimated (1985 1987) Z-score models. These samples included bankrupt and other financially distressed firms and included non-manufacturing as well as manufacturing firms. Subsamples were used to address the various research questions examined in this study. Table 1 reports descriptive statistics by distressed and non-distressed groups for the estimation and prediction samples. A comparison of the 1985 1987 distressed and non-distressed variable means indicates that working capital/total assets (X1), retained earnings/total assets (X2), and earnings before interest and taxes/total assets (X3) were lower in the distressed than in the non-distressed group. The p-values for the test of mean differences between distressed and non-distressed companies were significant for each of these variables. The means for market value of equity/book value of total debt (X4) and sales/total assets (X5) were not significantly different between the distressed and non-distressed groups, however. The descriptive statistics for Altmans variables using the 1985 1987 sample were similar to those reported by Altman for his estimation sample except for the market value variable, which was significantly different between his bankrupt and non-bankrupt groups. The descriptive statistics for the 1988 1991 prediction sample in Table 1 are similar to those of the 1985 1987 sample except for sales/total assets. The means for sales/total assets were significantly different between the distressed and non-distressed firms in the

Statistic

X1

X2 0.283 0.241

X3 0.107 0.081

X4

X5 2.264 1.235 3.156 0.812

Distresseda (n=148)

Mean 0.229 Standard 0.199 deviation Minimum 0.266 Maximum 0.858 Mean 0.092 Standard 0.389 deviation Minimum 2.410 Maximum 0.841 p-valueb 0.000

1.690 0.406 1.384 0.508 0.565 0.176 1.056 0.409

0.040 28.705 3.166 13.992

0.033 7.283 1.213 0.988

6.203 2.042 0.014 0.000 0.550 0.038 161.918 6.593 0.000 0.000 0.436 0.799

1988 1991 Sample Non-distresseda Mean 0.200 0.182 0.090 2.267 1.239 (n=854) Standard 0.208 1.794 0.110 4.058 0.760 deviation Minimum 0.684 2.427 1.722 0.361 0.002 Maximum 0.843 1.077 0.351 59.890 5.284 Distresseda Mean 0.061 0.773 0.122 2.268 1.622 (n=148) Standard 0.500 2.152 0.349 9.158 1.173 deviation Minimum 3.442 19.023 2.446 0.003 0.001 Maximum 0.861 0.663 0.301 101.802 6.633 p-valueb 0.000 0.000 0.000 0.998 0.000 X1 = working capital/total assets; X2 = retained earnings/total assets; X3 = earnings before interest and taxes/total assets; X4 = market value of equity/total assets; X5 = sales/total assets. a The distressed group includes companies that experienced bankruptcy or liquidation as well as those that received low S&P ratings for their bonds or stock. The non-distressed group includes companies that were rated by S&P and did not receive low bond or stock ratings. b p-Value of t-test of differences in variable means between the distressed and non-distressed groups.

The Compustat research file contains companies that were deleted from the annual industrial file because of bankruptcy (liquidation) and identifies bankrupt (liquidated) firms with a 02 (03) code for footnote 35. The files report S&P bond and stock ratings (data items 280 and 282). Companies whose bonds were rated CCC or below or whose stock was rated lower B or below were included in the distressed sample. 9 Companies that maintained codes for data item 280 (282) that were less than 19 (18) were included in the non-distressed sample. A random number generator was used to select the companies for the non-distressed group. Approximately 25% (18%) of the companies for each year in the 1985 1987 (1988 1991) sample were selected. These proportions were used to: (1) closely equate the number of non-distressed firms in each sample, and (2) reduce the opportunity for a firm to be selected in multiple years. Including firms in the non-distressed population that were not rated by S&P increased the non-distressed group by approximately 500 companies. These firms were not included in the results reported in this study because we could not assume firms were non-distressed just because they were not rated by S&P. The accuracy rates of the re-estimated models using the larger estimation sample were not significantly different from those reported in this study, however.

1988 1991 sample.10 The means for the market value variable were not significantly different between the distressed and non-distressed groups for the 1988 1991 prediction sample. Our sample included firms from all two-digit SIC codes for which data were available to calculate model variables. Financial institutions were excluded because Compustat does not include current asset and liability data for these firms. The 1985 1987 sample included 79 distressed and 435 non-distressed manufacturing firms (SIC code 2000 3999) and 69 distressed and 389 non-distressed non-manufacturing firms. The 1988 1991 sample included 78 distressed and 452 non-distressed manufacturing firms and 70 distressed and 402 non-distressed non-manufacturing firms. The 1985 1987 sample included 86 bankrupt companies and 62 companies that were financially distressed but that
10 Minimum and maximum values for certain variables indicated outliers in the sample. The results reported in this study did not change when the outliers were omitted, however. Specifically, the p-value for the X4 variable was affected by outliers, but the coefficients and explanatory power of the models were not affected when the outliers were removed. Details of these results are available from the authors.

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had not declared bankruptcy. Of the distressed companies, 26 eventually declared bankruptcy after 1987 and prior to 1997. The 1988 1991 sample included 92 bankrupt companies and 56 companies that were financially distressed but that had not declared bankruptcy. Of the distressed companies, 18 declared bankruptcy subsequent to 1991 and prior to 1997. The bankrupt firms were unique for the 1985 1987 and 1988 1991 samples. Twenty-two of the firms that were distressed in the 1985 1987 sample also appeared in the distressed group in the 1988 1991 sample. 2.2. Test procedures We evaluated the classification accuracy of Altmans Zscore model using the full 1988 1991 sample, a subset of the sample containing only bankrupt firms in the distressed group, and a subset of the sample containing only manufacturing firms in both distressed and non-distressed groups. The Z-scores were derived for each of these samples using Altmans coefficients from Eq. (1).11 The accuracy of the Z-score model was calculated by dividing the number of firms correctly predicted by the total number of firms in the sample. Binomial tests of proportions were used to test the significance of differences between the accuracies reported by Altman and those reported in the current study using the 1988 1991 sample. For the binomial test, p1 and p2 are defined as the proportion of successes (correct predictions) for two samples, n1 and n2. The test statistic is calculated as (p1p2)/sp1p2, where s is defined as the standard deviation of the binomial probability distribution. The binomial test is appropriate if nipi and ni(1pi) are greater than 5. The classification accuracy of Altmans model using a subset of the 1988 1991 sample containing only bankrupt firms was used to evaluate the models ability to assess financial distress other than bankruptcy. Binomial tests compared the models classification accuracy using the full 1988 1991 sample to the accuracy using the bankruptcy subset. The Z-score models classification accuracy using a subset of the 1988 1991 sample containing only manufacturing firms was used to evaluate the sensitivity of the model to non-manufacturing industries. Binomial tests compared the models classification accuracy using the full 1988 1991 sample to the accuracy using the manufacturing subset of the sample. To compare results from Altmans original model with those from a more recent period, the Z-score models coefficients were re-estimated using the 1985 1987 estimation sample. The coefficients were re-estimated using the methodology Altman originally employed to derive

his model, discriminant analysis (DA). Arguably, DA is no longer the prevalent statistical methodology used by bankruptcy prediction researchers to develop prediction models.12 The use of DA was necessary in this study so direct comparisons could be made between the coefficients in the original and re-estimated Z-score score models.13 We compared the coefficients of the 1985 1987 model to those shown in Eq. (1) to test the stationarity of the model. Also, we compared the magnitude and significance of the coefficients for the manufacturing-only and bankruptcy-only models to those for the 1985 1987 model to evaluate whether re-estimations of Altmans model were sensitive to industry classifications or financial conditions. Binomial tests compared the accuracies of the re-estimated models to those using Altmans original model.

3. Results This section reports test results used to evaluate the generalizability of Altmans model. These results are divided into two primary categories. The first are those using coefficients from Altmans 1968 model. The second are those using our 1985 1987 estimation sample to recompute model coefficients. 3.1. Classification accuracy of Altmans (1968) model Table 2 reports results of tests of Altmans (1968) model. The table contains four panels. Panel A contains the classification results from Altmans study. Panel B contains the classification results using Altmans model to predict outcomes for our 1988 1991 sample. The overall correct classification rate dropped from 83.5% in Panel A to 57.8% in Panel B, a significant difference at the 0.05 level using the binomial test. Classification rates for both the distressed and non-distressed groups were significantly lower in the 1988 1991 sample than in the original sample. These results indicate that Altmans model is not as useful for predicting financial distress in recent periods as it was in the 1960s.

11 Firms were classified as distressed if their Z-scores were < 2.675 (Altman, 1968). Firms with a 2.675 Z-score had approximately a 50% chance of being classified as distressed in Altmans study.

See Jones (1987) for detailed discussions of DA and other statistical methodologies used in bankruptcy prediction research. 13 Linear models, such as Eq. (1) derived using DA, assume the variance covariance matrices of the distressed and non-distressed groups are equal. Unequal variance covariance matrices for the groups suggest that a quadratic discriminant function may be more suitable for the sample. Altmans (1968) study does not report information related to this assumption. However, prior research suggests that the samples used to derived bankruptcy prediction models typically violate the equal variance covariance matrix assumption (Jones, 1987). The estimation sample used in this study violated the equal variance covariance assumption based on Bartletts test of homogeneity. Further analysis indicated no significant differences between the accuracy rates of the quadratic and linear discriminant models, however.

12

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Table 2 Comparisons of classification accuracies using coefficients from Altmans (1968) model Sample Panel A Altmans (1968) sample Panel B 1988 1991 sample Statistic Accuracya n Overall 83.5% 91 Distressed group 96.0% 25 Non-distressed group 78.8% 66

were lower for the 1988 1991 sample, but the difference was not significant at the 0.05 level. A comparison of Panel D results with those for Panel B indicates that classification results for the manufacturing sample were significantly higher than those for the total 1988 1991 sample. These results suggest that Altmans model is more useful for predicting financial distress of manufacturing firms than for predicting financial distress of non-manufacturing firms. 3.2. Classification accuracy of a re-estimated model Additional evidence of the stationarity of the Z-score model was obtained by re-estimating the models coefficients using our 1985 1987 sample. Table 3 reports results for the re-estimated model. Data are reported for four models. The first column of coefficients contains those for Altmans (1968) model. The second column contains those for the re-estimation sample from 1985 to 1987. A comparison of these columns reveals several differences in the coefficients. Most of the coefficients for the 1985 1987 model are lower than those for Altmans original model, and most of these changes are quite large, suggesting the model is not stationary. Differences between the univariate F statistic for Altmans original and the 1985 1987 models reported in Table 3 provide further indication of a stationarity problem. The retained earnings/total assets and earnings before interest and taxes/total assets variables exhibit higher significance levels in the 1985 1987 model than in Altmans original model. The market value of equity/book value of total debt variable has a higher significance level in the original model, and the working capital/total assets and sales/total assets variables maintained about the same level of significance. Multivariate significance tests of the coefficients for the 1985 1987 sample revealed that only the retained earnings/ total assets and earnings before interest and taxes/total assets coefficients were significant at the 0.05 level. Altman did not report the multivariate significance of his tests; however, he indicated that each ratio provided significant information in the original Z-score model. Limiting the 1985 1987 sample to bankrupt firms for the distressed group or to manufacturing firms for both distressed and non-distressed groups had relatively little effect on model coefficients or significance tests. The third column of numbers in Table 3 reports results for the bankruptcy sample, and the fourth column reports results for the manufacturing sample. A comparison of these numbers with the second column reveals the results are similar for most variables. Coefficients for the working capital/total assets variable were lower for the bankruptcy and manufacturing samples than for the total sample of 1985 1987 firms. A comparison of columns three and four with column one again indicates that the original model is not stationary, even if only bankrupt or only manufacturing firms are included in the sample.

Accuracya n Test statisticb

57.8% 979 4.748*

70.9% 148 2.552*

55.5% 831 3.668*

Panel C Bankruptcy samplec

Accuracya n Test statisticd Test statisticb

56.1% 972 0.779 5.045*

68.2% 85 0.439 2.621*

54.9% 887 0.238 3.762*

Panel D Manufacturing samplec

Accuracya n Test statisticd Test statisticb

69.1% 547 4.283* 2.755*

69.2% 78 0.270 2.524*

69.1% 469 4.741* 1.597

a Accuracy rates represent correct classifications using Altmans (1968) model coefficients. b Test statistic for binomial tests comparing the accuracy rates to those in Panel A. c The manufacturing and bankruptcy samples are subsets of the 1988 1991 sample. d Test statistic for binomial tests comparing the accuracy rates to those in Panel B. * Significant at the 0.05 level.

The sample used in Panel B includes both bankrupt and other financially distressed firms, perhaps explaining the lower classification rates. Panel C includes only bankrupt firms in the distressed group for the 1988 1991 sample. A comparison of these results with those in Panel A and Panel B reveals that the classification rates for the bankrupt firms were significantly lower in the 1988 1991 sample than in the original sample. Further, the classification rates for the bankrupt firm sample were approximately the same as that for the Panel B sample. These results indicate that Altmans model predicts financial distress other than bankruptcy with the same accuracy as it predicts bankruptcy. Consequently, the lower accuracy of Altmans model for the 1988 1991 sample was not due to the inclusion of non-bankrupt firms in the distressed group. Panel D of Table 2 reports results for the 1988 1991 sample when the sample is limited to manufacturing firms. A comparison of these results with those in Panel A reveals that the prediction accuracy was significantly lower for the 1988 1991 sample than for the original sample. The overall accuracy for the 1988 1991 sample was 69.1%, compared to the rate of 83.5% for Altmans sample. Classification results for the distressed group were significantly lower for the 1988 1991 sample. Those for the non-distressed group

J.S. Grice, R.W. Ingram / Journal of Business Research 54 (2001) 5361 Table 3 Coefficients for Altmans (1968) and 1985 1987 re-estimated models Variables and statistics Working capital/total assets p-Value Univariate F Retained earnings/total assets p-Value Univariate F Earnings before interest and taxes/total assets p-Value Univariate F Market value equity/book value debt p-Value Univariate F Sales/total assets p-Value Univariate F Altmans (1968) modela 1.200 32.66* 1.400 58.86* 3.300 26.56* 0.600 33.26* 0.990 2.840 1985 1987 modelb 0.058 0.831 39.67* 1.504 0.000 387.37* 2.073 0.000 289.23* 0.014 0.129 3.025 0.058 0.396 0.261 Bankruptcy-only modelc 0.301 0.307 19.573* 1.599 0.000 369.01* 2.627 0.000 309.12* 0.033 0.001 11.41* 0.157 0.033 1.050

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Manufacturing-only modeld 0.386 0.345 9.67* 2.067 0.000 278.84* 1.385 0.019 185.33* 0.005 0.607 2.815 0.069 0.557 0.249

p-Value: multivariate significance of the coefficient in the full model. Altman did not report the multivariate significance of his coefficients. Univariate F: individual discriminating ability of each ratio. a Coefficients and significance levels reported in Altmans (1968) study (N = 66, 33 bankrupt and 33 non-bankrupt firms). b Coefficients estimated using the full 1985 1987 sample (N = 972, 824 non-distressed and 148 distressed companies). c Coefficients estimated using a subset of the 1985 1987 sample that included only bankrupt companies in the distressed group (N = 910, 824 nondistressed and 86 distressed firms). d Coefficients estimated using a subset of the 1985 1987 sample that included only manufacturing companies (N = 555, 476 non-distressed and 79 distressed firms). * Significant at the 0.05 level.

Table 4 reports predictive accuracies using coefficients estimated from the 1985 1987 model. These coefficients were used to predict outcomes for the 1988 1991 sample and can be compared to results in Table 2. The four panels in Table 4 parallel those in Table 2. Panel A reports the classification accuracies of Altmans 1968 model when

used to predict outcomes for the 1988 1991 sample. Panel B reports the classification accuracies using the 1985 1987 reestimation model to predict outcomes for the 1988 1991 sample. Classification results for the reestimation sample were significantly higher for the reestimation model than for Altmans original model. Binomial test

Table 4 Comparisons of the classification accuracy of Altmans (1968) model and the 1985 1987 re-estimation model Model Panel A Altmans (1968) Panel B 1985 1987 Re-estimationb Statistic Accuracya Overall 57.8% Distressed group 70.9% Non-distressed group 55.5%

Accuracya Test statisticc

88.1% 13.657*

54.7% 3.702*

93.8% 15.871*

Panel C Bankrupt firmsd

Accuracya Test statisticc

87.6% 13.243*

48.6% 4.225*

94.9% 15.989*

Panel D Manufacturing firmse

a

Accuracya Test statisticc

86.4% 12.681*

55.4% 2.945*

92.1% 14.871*

Accuracy rates represent the correct classifications for each model using the 1988 1991 sample. Model coefficients are reported in Table 3. c Test statistic comparing the re-estimated models accuracy rates to those of Altmans (1968) model. d Model estimated using a subset of the 1985 1987 sample that included only bankrupt firms from the distressed group. Model coefficients are reported in Table 3. e Model estimated using a subset of the 1985 1987 sample that included only manufacturing firms. Model coefficients are reported in Table 3. * Significant at the 0.05 level.
b

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results were significant at the 0.05 level. These results also hold for Panel C that includes only bankrupt firms in the nondistressed group and for Panel D that includes only manufacturing firms in the distressed and nondistressed groups. The overall classification results for Panel B, C, and D are similar to those reported by Altman in his 1968 study (see Panel A of Table 2). A comparison of results for the distressed and nondistressed groups in the re-estimation model in Panel B of Table 4 with those of Altmans original model in Panel A indicates that the Type I and Type II error rates differ between the models. Accuracy rates for the distressed group were higher for Altmans model than for the re-estimation model, while accuracy rates for the non-distressed group were lower for Altmans model. These results demonstrate the effect of using proportionate samples of distressed and non-distressed companies in the re-estimation model. Altman used a matched sample of 33 bankrupt and 33 nonbankrupt firms and, accordingly, ignored the prior probabilities of group membership. The 1985 1987 models were developed using proportionate samples of distressed and non-distressed companies. As a result, the Type I (Type II) errors for the Altman (1968) model were lower (higher) than those for the re-estimated models.14 These results hold for the bankrupt only and manufacturing only samples as well as for the total sample.

the model for bankrupt companies (56.1%) in the 1988 1991 sample was not significantly different from that of the entire sample (57.8%) that included other financial distress situations. Other results of this study indicate that those who employ Altmans Z-score model should re-estimate the models coefficients rather than relying on those reported by Altman (1968). Because the coefficients are not stable, significantly better classification results were achieved when the models coefficients were re-estimated using 1985 1987 data than when the original coefficients were used. Finally, care should be used in applying Altmans model because of the potential underestimation of Type I and overestimation of Type II errors that result from using non-proportional samples of bankrupt and non-bankrupt firms. This problem can be overcome by re-estimating Altmans model coefficients using a sample of firms that approximates the proportions of distressed and non-distressed firms in the population. In conclusion, our findings suggest that results of recent studies that have used Altmans model to estimate financial distress of sample firms should be interpreted cautiously. The ability of the model to accurately classify firms as being financially distressed is likely to differ considerably from that assumed by those employing the model.

4. Summary This study evaluated the generalizability of Altmans (1968) Z-score model using a proportionate sample of distressed and non-distressed companies from time periods, industries, and financial conditions other than those used by Altman to developed his model. The findings indicated that the accuracy of Altmans model declined when applied to our samples. Altman reported an 83.5% overall accuracy for his model using a sample from 1958 to 1961. The overall accuracy for the 1988 1991 sample used in this study was 57.8%. Additionally, the coefficients of Altmans (1968) model changed dramatically when re-estimated using a 1985 1987 sample. Thus, it appears the relation between financial ratios and financial distress changes over time. Altmans model was sensitive to industry classifications in the sample used in this study. The overall accuracy of the model was significantly higher for manufacturing firms (69.1%) than for the entire sample (57.8%) that included non-manufacturing firms. Altmans model was not sensitive to type of financial distress. The overall accuracy of
14 Begley et al. (1996) also ignored the prior probabilities of group membership when they re-estimated Altmans (1968) coefficients using a matched sample of 100 bankrupt and 100 non-bankrupt firms. Binomial tests indicated that their re-estimated model was significantly more (less) accurate at predicting bankrupt (non-bankrupt) firms than the 1985 1987 model.

Acknowledgments We gratefully acknowledge comments from Mike Dugan, Rich Houston, Mary Stone, Gary Taylor, and an anonymous reviewer.

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