FINANCIAL STATEMENT AS INSTRUMENT FOR PREDICTING

CORPORATE HEALTH IN NIGERIA

A PAPER PRESENTED AT 4TH ANNUAL CONFERENCE OF THE

DEPARTMENT OF FINANCE UNIVERSITY OF LAGOS

BY

CHARLES ONYEIWU

DEPARTMENT OF FINANCE

UNIVERSITY OF LAGOS

ABSTRACT

The level of urban unemployment among youths is 43 percent (C.B.N 2008) and the rate
of business failure and financial loss has reached unacceptable level resulting in socially
undesirable effects. This study therefore applies a Multiple Discriminant Analysis
technique to Nigerian Organizations to ascertain its ability to effectively discriminate
between healthy and unhealthy Organizations in the Nigerian manufacturing industry.
Twenty Organizations within the production industry were randomly selected for
investigation and Z score model developed by Altman (1968) was applied to their last
published accounts. There was 70 percent right classification of healthy Organizations
and 80 percent correct classification of unhealthy Organizations.

Keywards: Financial statement, corporate health, prediction and financial ratios

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1.0 Introduction

There seem to be sign of recovery of many economies from the global economic melt
down as evident in Nigeria where the capital market has shown visible signs of recovery
with market capitalization rising from N4.5 trillion in March 2009 to N7.8 trillion by
June 2011 and rude oil price recovering from a mere $36 per barrel on February 27, 2009
to $105 per barrel in June 2011. Step is to be taken to sustain the recovery and ensure that
the mistake of the past years where both government and investors are caught unaware is
avoided. The global financial crisis has forced a few Organizations to liquidate with
attendant huge financial loss to investors and tremendous revenue loss to government.
This situation is avoidable and to forestall future reoccurrence, regulatory agencies and
investors have to have a way of evaluating the health of Organization where they have
some stake. It is in line with this thinking that one of techniques of evaluating an
Organizations health known as Multiple Discriminant Analysis, (MDA) is being
examined in the Nigerian context to ascertain it suitability in discriminating between
healthy and unhealthy Organizations. MDA, is a multivariate technique of analyzing
Financial Statements.

Financial statements are qualitative and quantitative statements of the operations and
performance of an Organization within a specified period. The basic objective of
financial statements is to provide useful information for making economic and financial
decisions. Financial ratios are a popular tool for analyzing Financial Statements by
shareholders, creditors, investors, governments and other users to evaluate the financial
condition and performance of a company . Besides, they also help the auditors judge the
adequacy of financial reporting of the Organization. A study in 1930s and several ones

1
later conclude that failing firms exhibit significantly different ratio measurements than
continuing entities. Therefore, observed evidence for five years prior to failure was cited
as conclusive evidence that ratio analysis can be useful in the prediction of failure. Ratio
analysis has been used by analyst to measure the performance of business Organizations.
In the 1970s and early 1980s it was considered suspect but the market crisis of 1987
brought back confidence in the use of financial ratio. Financial ratio has two problems
which are the computation of one ratio at time approach and the subjective choice of
ratios to examine the overall health of an Organization. However financial ratio has been
validly proved to be a good measure of performance of a firm (Beaver1966). His was the
first attempt to use statistical or mathematical tools to predict business health.
Altman(1968) was the second but, unlike Beaver who used a univariate method; Altman
used the multivariate method known as multiple discriminant analysis model for business
failure prediction.

Accurate Business Failure Prediction (BPF) models would be extremely valuable to

many Industrial sectors, particularly in financial, investment and lending. The potential
value of such models has been recently emphasized by the extremely costly failure of
high profile businesses in both Australia and overseas, such as HIH (Australia) and Enron
(USA). Consequently, there has been a significant increase in interest in business failure
prediction from both industry and academia. Statistical business failure prediction
models attempt to predict the failure or success of a business. The advantages of accurate
business failure prediction models are that:
Banks,
investment banks, credit unions, and other financial institutions could avoid
lending to a business that will fail, and thus never repay their loans.
The
financial/ investment sector could improve the risk return trade-off from
investments by not investing in failing businesses.
Businesses
could establish long-term relationships with other businesses (such as
suppliers) that will not fail in the future, and thus increase the longevity and viability of
their business relationships.
Regulatory
bodies, such as the Central Bank of Nigeria, Nigerian Deposits Insurance
Corporation and the Securities and Exchange Commission could make early
identifications of failing businesses Individuals and other entities dealing with businesses
could also profit from using accurate BFP models in order to preferentially deal with
2
successful businesses. Overall, accurate BFP models will increase peoples confidence in
investment, lending and the development of profitable business relationships, which will
result in increased stable economic growth for the benefit of all involved.

The objective of this paper therefore, is to apply one of the popular failure prediction
models known as the Multiple Discriminant Analysis(MDA) to Nigerian public
companies in the manufacturing industry to ascertain its suitability in identifying failing
Organizations in Nigeria. This would be a baseline work which would facilitate future
modification to address some peculiarities of Nigerian companies. This paper is to be
organized as follows: part one is the introduction, part two is the literature review, part
three, is the methodology, part four is the result and part five concludes with the
summary, conclusion and policy recommendations.

2.0 Literature

Business Failure Prediction Models (BFP): A Brief Review

Many different techniques have been applied to BFP since its beginnings in the
1960s. The field arguably started earlier, but the first statistical and mathematical
models for BFP were published in th1960s. Beaver (1966) presented a univariate
model, and then Altman (1968) pioneered the use of Multiple Discriminant Analysis
(MDA) that was further developed by Deakin (1972), Edminster (1972) and others.
Ohlson (1980) in his pioneer study, to avoid some significant problems associated
with MDA, employed conditional Logit Analysis (LA) for predicting the survival of
businesses. LA does not require normality or equal co variances, which are pre-
requisites for MDA. Subsequently both logit and probit models have been used with a
focus of providing a measure of probability of business failure. Kumar and
Ganesalingam (2001) have since focused on predicting the financial distress of a
selection of major Australian companies. This research used principal component
analysis, factor analysis, discriminant analysis and cluster analysis, Theodossiou
(1993) introduced a sequential procedure to predict a business tendency towards
failure. This procedure is based on the hypothesis that signals of a business
deteriorating condition are produced sequentially for many years prior to failure. As

3
 the business economic condition deteriorates, its financial characteristics shift
towards those of failed businesses and this procedure detects that shift. Theodossious
CUSUM procedures for BFP had excellent empirical results. The soft computing
methods known as artificial neural networks (ANNs) have also been used in BFP.
Unlike traditional statistical techniques, ANNs do not require any restrictive
assumptions such as linearity, normality and independence among input variables.
These soft computing models are important as they offer qualitative methods that
traditional quantitative tools in statistics and economics can not quantify due to the
complexity of translating the systems into precise functions. ANNs have been shown
to be good at classifying businesses into various groups based on financial distress.
There are many research papers that apply ANNs to BFP, such as Odom and Sharda
(1990) and Fletcher and Goss (1993) who respectively compared the performance of
an ANN with a discriminant analysis and logit analysis model. More information
about the various ANN methods applied in BFP is summarized in a book by Tan
(2001). There are also numerous other techniques that have been applied to BFP. For
example, Wilcox (1976) applied the Gambler ruin model taken from probability
theory to predict business risk and Casey (1980) used the human information
processing (HIP) model to show that operating cash flow data can lead to more
accurate predictions of business failure.

The multiple discriminant analysis technique (MDA) and the logit analysis (LA) have
become most popular in Business Failure Prediction (BFP) and the only alternative to
these main techniques is the Cox model. The prediction accuracy of the Cox model was
found to be comparable with MDA on the initial and hold-out data, but the Cox model
produced lower Type I Errors. In addition, Crapp and Stevenson (1987) applied a Cox
model to some Australian credit unions with similar encouraging results. Laitinen and
Luoma (1991) also empirically compared the classification accuracy of the Cox model
with MDA and LA using, 36 failed Finnish limited companies and 36 successful
counterparts. Their predictions were made by dividing the businesses into two groups
based on their hazard ratios, according to the ratio of failed and successful businesses in
the original sample (equal groups in this case). Although the techniques were
comparable, MDA and LA were found to be slightly superior predictors to the Cox
model. Laitinen and Kankaanp (1999) presented a comparative study, in which the Cox
model along with MDA, LA, RPA (a decision tree approach), ANN and HIP were
analyzed. The six techniques were empirically compared for their 1, 2 and 3 year
4
prediction accuracy using a data set containing three explanatory variables from 76
Finnish companies (with equal number of success and failures). They concluded that
there were no statistically significant differences in the predictive powers of any of the
six models. Lane et al. (1986) found the Cox model to slightly empirically outperform
MDA, but Laitinen and Kankaanp (1999) found no overall statistical difference
between the empirical performance of MDA and LA. Therefore, it would be valuable
research to apply the Cox model to a large set of data and compare it to both DA and LA
again. Furthermore, comparing the techniques across different misclassification costs has
never been done.

The traditional financial ratios have come under attack in the past. For example, the
detection of company operating and financial difficulties is a subject which has been
particularly susceptible to financial ratio analysis. Ratio analysis presented using
univariate analysis is susceptible to faulty interpretation and is potentially confusing.
For instance, a firm with poor profitability and /or solvency record may be regarded
as a potential bankrupt. However, because of its above average liquidity, the situation
may not be considered serious. The potential ambiguity as to relative performance of
several firms is clearly evident. The crux of the shortcomings inherent in any
univariate analysis lies therein. What is important and which should be done is to
build upon the finding s of previous analysis and to combine several measures into
meaningful predictive model. In so doing, the highlights of ratio analysis as an
analytical technique will be emphasized rather than downgraded and therein lies the
argument for adopting the Multiple Discriminant Analysis to Nigerian businesses.

The multiple discriminant analysis (MDA) has been utilized in a variety of disciplines
since its first application in the 1930s. During those earlier years MDA was used mainly
in the biological and the behavioral sciences. In recent years, this technique has become
increasingly popular in the practical business world as well as in academia. Altman
(2000) discuss discriminant analysis in depth and reviews several financial application
areas.

Multiple discriminant analysis is a statistical technique used to classify an observation

into one of several a priori groupings dependent upon the observations individual
5
characteristics. It is used primarily to classify and/or make predictions on problem where
the dependent variable appears in qualitative form, for example male or female, bankrupt
or non bankrupt. Therefore, the first step is to establish explicit group classification. The
number of original group can be two or more. Some analysts refer to discriminant
analysis as multiple only when the number of the groups exceeds two. But the multiple
concepts refer to the multivariate nature of the analysis.

After the groups are established, data are collected for the objects of the groups: if a
particular object, for instance, a corporation, has characteristics (financial ratios) which
can be quantified for all the companies in the analysis, the MDA determines a set of
discriminant coefficients. When these coefficients are applied to the actual ratios, a basis
for classification into one of the mutually exclusive groupings exists. The multiple
discriminant analysis technique has the advantage of considering an entire profile of
characteristics common to the relevant firms as well as the interaction of these properties.
A univariate study, on the other hand can only consider the measurements used for group
assignments one at a time

Another advantage of multiple discriminant analysis is the reduction of the analysts

space dimensionally that is from the number of different independent variables to G-1
dimension(s) where G equals the number of original a priori group, consisting of
bankrupt and non bankrupt firms. Therefore, the analysis is transformed into its simplest
form: one dimension, the discriminating function of the firm

Z = V1X1 +V2X2 + VnXn transform the individual variable values to a single

discriminant score or Z value which is then used to classify the object where V1, X2
Vn= discriminant coefficients, and V1X2.Xn = independent variable

The multiple discriminant analysis computes the discriminant coefficient: V1 while the
independent variable X1 are the actual values.

When utilizing a comprehensive list of financial ratios in assessing a firms bankruptcy

potential, there is reason to believe that some of the measurements will have high degree
of correlation or co linearity with each other. While this aspect is not serious in
discriminant analysis, it usually motivates careful selection of the predictive variables
(ratios). It also has the advantage of potentially small number of selected measurement
which convey a great deal of information which might very well indicate differences

6
among groups, but whether or not these differences are significant and meaningful is a
more important aspect of the analysis

Perhaps the primary advantage of the multiple discriminant analysis in dealing with
classification problems is the potential of analyzing the entire variable profile of the
object simultaneously rather than sequentially examining its individual characteristics.
Just as linear and integer programming have improved upon traditional techniques in
capital budgeting, multiple discriminant analysis approach to traditional ratio analysis has
the potential to reformulate the problem correctly. Specifically, combination of ratios can
be analyzed together in order to remove possible ambiguities and misclassifications
observed in earlier traditional ratio studies

The Z score is a linear analysis in that five measures are objectively Weighted and
summed up to arrive at an overall score that then becomes the basis for classification of
firms into one of the a priori groups (distress and non distress). The specific variables in
the Z score are X1, X2 X3 X4 and X5 representing working capital/total assets, retained
earning/total assets, earning before interest and tax/total asset, market value of
equity/total liabilities and sales/total assets respectively.

Working capital/Total asset, frequently found in studies of corporate problems, is a

measure of the net liquid assets of the firm relative to the total capitalization. Working
capital is defined as the difference between current assets and current liabilities.

Retained earnings/Total assets measure the cumulative profitability overtime was cited
earlier as one of the New ratios. The age of a firm is implicitly considered in this ratio...
For example, a relatively young firm would probably show a low RE/TA ratio because it
has not have time to build up its cumulative profits. Therefore, it may be argued that the
young firm is somewhat discriminated against in this analysis, and its chance of being
classified as bankrupt is relatively higher than another older firm ceteris paribus. But, this
is precisely the position in the real world. The incidence of failure is much higher in a
firms earlier years.

7
Earning before interest and tax/Total assets are calculated by dividing the total assets
of a firm into its earning before interest and tax reduction. In essence, it is a measure of
the true productivity of the firms assets, abstracting from any tax or leverage factors.
Since a firms ultimate existence is based on its earning power of its assets, this ratio
appears to be particularly appropriate for studies dealing with corporate failure.

Market value of equity/ total asset: equity is measured by the combined market value of
all shares of stock; preferred and common, while liabilities include both current and long.
The measure shows how much the firms assets can decline in value (measured by market
value of equity plus debt) before the liabilities exceed the assets and the firm becomes
insolvent.

Sales/ Total sales (S/TA) is measure of the firms asset utilization. It is one measure of
managements capacity in dealing with competitive conditions. This ratio is quite
important because it is the least significant ratio on an individual basis but has a unique
relationship with other variables in the model. In fact it ranks second in its contribution to
overall discriminating ability of the Z score model

3.0 Methodology

Drawing from an earlier study where a set of financial and economic ratios were
investigated in a bankruptcy prediction context using a Multiple Discriminant
Statistical Methodology (Altman, 1968), the data used in the study are limited to
manufacturing Organizations in Nigerian capital market. The discriminant model is
applied to a sample of twenty Organizations for a period of one year using the last
published account available for the organization (range is 2005 to 2009) to establish a
function which best discriminates between Organizations in two mutually exclusive
groups: healthy and weak Organizations. Random sample was used to pick twenty
Organizations in Nigerian manufacturing industry.

Data Source

The data is extracted from classification made by a Cash craft Ltd, an Asset
management company (www.cashcraft.com). All public companies are ranked in the
8
 order of performance, using return on investment and price movement. in conducting
this research we classify first 10 most performing Organizations as the healthy ones
and the 10 least performing Organizations as the unhealthy one.

Limitation of Study

The last available Financial Statements for the chosen companies are used as such
there is no uniformity in accounting dates which may introduce bias to the conclusion
and the reader should appreciate that the study adopts static concept since historic
accounting figures are used and therefore there is need for caution in using the
outcome of such technique in analyzing Organizations health.

Classification criteria

To identify which company would be classified as either healthy or unhealthy, we

extract the relevant variables from the financial statement of each Organization as in
Table 1 and calculate the relevant ratios.

Table 1

retained Market value of

COY. NAME working.capital Asset earning EBIT equity Book value of liabilities
1 INTERBREW -694439165 625837204 -1851493092 221095301 15001694242 623645831
2 CAPALBETO 1575752000 8809824000 836150000 1280343000 1785656250 6916505000
3 CADBURY -13,867,189,000 23,901,206,000 -2,689,742,000 -715525000 31,252,865,116.63 26,913,976,000
58,500,000 426,547,000 14,429,000 214,561,000.00
4 VONO 26800000
5 JBERGER -3014280000 32008528000 323110000 888142000 12375000000 30090928000
6 ALUMACO -3275000 1119708000 -38971000 107954000 616140000 453102000
7 DANGFLOUR -4636107000 58119789000 524710000 2379264000 1.01E+11 35974655000
8 OASISINS 3417373000 3464996000 72881000 263743000 3102173720 3459976000
9
9 DNMEYER 100672000 1097222000 60753000 266417000 1209682836 933865000
10 COSTAIN 1701834000 13875448000 0 -574787000 6674159144 5183448000
11 FLOURMILLS 2398176 1.3752E+11 3815438000 11141940000 1.17861E+11 1.00E+11
12 CONOIL 3532485000 28969202000 88935000 4241676000 36432486143 25436717000
13 BAGCO 3802982000 16266831000 303551000 4008197000 16842650000 6890502000
14 MOBIL -4711697000 8697680000 1764645000 4712010000 41990116217 6449332000
15 NEIMETH 1919047000 3270432000 98267000 352130000 1748311600 1636357000
16 UNIONDICON -195841000 2096825000 0 366879000 710400000 1030968000
17 OKOMU 443921000 3475144000 103924000 231934000 4540611600 2810812000
18 POLYPROD -44734000 867272000 13675000 199283000 712800000 246989000
19 WAPIC 657976000 2269777000 80414000 357857000 533333333.1 760429000
20 GOLDBRE 74454307 1479411390 7649756 11906868 135451440 758434502
Source (www.cashcraft.com): Respective companys annual reports.

The ratios to be calculated are provided by Altman (1968) as

X1= Working capital/Total assets

X2= Retained earning/Total assets

X3= Earning before interest and tax/Total assets

X4= Market value of equity/ Book value of total liabilities

X5= Sales/ Total assets

Z = Overall Index

In the original work carried out by Altman (1968) and subsequent one in 2000, he
gave basis for classifying public quoted companies in the manufacturing sector as
either bankrupt or non bankrupt. There is a standard Z score model given below
which has been tested for more than 30 years in different countries and has been
proved to be effective in correctly classifying companies into bankrupt or non
bankrupt status.

Model Z= 0.012X1 + 0.014X2 + 0.033X3 +0.006X4 + 0.999X5

10
 Altman advise that variables X1 through X4 must be calculated as absolute
percentage values. For instance, the firm whose net working capital to total assets (X1
is 10% should be included as 10.0% and not .10. Only variable X5 (sales to total
assets) should be expressed in a different manner: that is S/TA ratio of 200% should
be included as 2.0

Over the years, however, many individuals have found a more convenient
specification of the model:

Z= 1.2X1 +1.4X2 +3.3X3 +0.6X4 +1.0X5

In classifying an Organization

Z 2.99 Safe Zones

1.80 Z 2.99.Grey Zone

Z 1.80 . is bankrupt or nearly so.

4.0 FINDINGS

On application of ratios X1, X2, X3 X4 and X5 extracted from data on Table 1 above,
we obtain the Z value of each Organization as reflected in table 2 below.

Table 2

s/n year Firm X1 X2 X3 X4 X5 Z

1 2008 INTERBREW -1.11 -2.96 0.35 24.05 1.49 11.6
2 2007 CAPALBETO 0.18 -95 0.15 0.26 0 0.98
3 2008 CADBURY -0.58 -0.11 -0.03 0 1.16 0.76
4 2003 VONO 0.14 0.034 0.06 0 1.03 1.45

11
5 2002 JBERGER -0.094 0.01 0.03 0.41 0.83 1.07
6 2007 ALUMACO -0.04 -0.04 0.1 1.36 0.37 1.45
7 2007 DANGFLOUR -0.08 0.01 0.04 2.81 0.73 2.46
8 2007 OASISINS 0.99 0.021 0.08 0.9 0.08 2.08
9 2009 DNMEYER 0.09 0.06 0.24 1.3 1.83 3.6
10 2009 COSTAIN 0.12 0 -0.04 1.29 0.45 1.23
11 2009 FLOURMILLS 1.74 0.03 0.08 1.18 1.31 2.32
12 2005 CONOIL 1.12 0 0.15 1.43 2.61 4.1
13 2008 BAGCO 0.23 0.02 0.25 2.44 0.73 3.31
14 2007 MOBIL -0.54 0.2 0.54 6.5 6.27 11.6
15 2008 NEIMETH 0.59 0.03 0.11 1.07 0.6 2.34
16 2002 UNIONDICON -0.09 0 0.17 0.69 0.84 1.71
17 OKOMU 0.13 0.03 0.07 1.62 0.32 1.71
18 2007 POLYPROD -0.05 0.02 0.23 2.89 1.95 4.4
19 2005 WAPIC 0.29 0.04 0.16 0.7 0.74 2.08
20 2002 GOLDBRE 0.05 0.01 0.01 0.18 0.54 0.75
Source: Researcher computation from annual reports

With the table 2 we are able to classify those that have Z of 2.10 and above as healthy
and those with Z below 2.10 as unhealthy as Tables 3a and 3b reflect. (Note that the
cut off is 1.80 but we decided to slightly increase the benchmark to 2.10.)

Table 3a (healthy companies)

X1 X2 X3 X4 X5 Z
1 2008 INTERBREW -1.11 -2.96 0.35 24.05 1.49 11.6
2 2007 DANGFLOUR -0.08 0.01 0.04 2.81 0.73 2.46
3 2009 DNMEYER 0.09 0.06 0.24 1.3 1.83 3.6
4 2009 FLOURMILLS 1.74 0.03 0.08 1.18 1.31 2.32
5 2005 CONOIL 1.12 0 0.15 1.43 2.61 4.1
6 2008 BAGCO 0.23 0.02 0.25 2.44 0.73 3.31
7 2007 MOBIL -0.54 0.2 0.54 6.5 6.27 11.6
8 2008 NEIMETH 0.59 0.03 0.11 1.07 0.6 2.34
9 2007 POLYPROD -0.05 0.02 0.23 2.89 1.95 4.4
1.99 -2.59 1.99 43.67 17.52 45.73
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 Average 0.22 -0.29 0.22 4.85 1.95 5.08

Source: Researcher computation from annual reports

Table 3b (unhealthy companies)

X1 X2 X3 X4 X5 Z
1 2007 CAPALBETO 0.18 -95 0.15 0.26 0 0.98
2 2008 CADBURY -0.58 -0.11 -0.03 0 1.16 0.76
3 2003 VONO 0.14 0.034 0.06 0 1.03 1.45
-
4 2002 JBERGER 0.094 0.01 0.03 0.41 0.83 1.07
5 2007 ALUMACO -0.04 -0.04 0.1 1.36 0.37 1.45
6 2007 OASISINS 0.99 0.021 0.08 0.9 0.08 2.08
7 2009 COSTAIN 0.12 0 -0.04 1.29 0.45 1.23
8 2002 UNIONDICON -0.09 0 0.17 0.69 0.84 1.71
9 OKOMU 0.13 0.03 0.07 1.62 0.32 1.71
10 2005 WAPIC 0.29 0.04 0.16 0.7 0.74 2.08
11 2002 GOLDBRE 0.05 0.01 0.01 0.18 0.54 0.75
-
1.096 95.005 0.76 7.41 6.36 15.27
Average 0.10 -8.64 0.07 0.67 0.58 1.39
Source: Researcher computation from annual reports

From the above there is a 70% correct classification of healthy companies and 80
percent correct classification of the unhealthy companies. There is 10 percent chance
of committing type 1 error and 20 percent chance of committing type two errors.

13
 This is a very good resulting indicating that the Z score could be useful in the
Nigerian business environment

CONCLUSION

This study aims to examine the applicability of the multiple discriminant analysis by
Altman (1968) to Nigerian manufacturing sector which necessitates selecting twenty
Organizations, one half of which have been classified as healthy and the other half as
unhealthy using some other criteria. The last available financial statement of each
Organization is subjected to the Z score model giving a result of right classification
for 70 percent of the companies which have earlier been classified as healthy and 80
percent correct classification of the same companies that have earlier been classified
unhealthy. This shows that the multiple discriminant analysis is quite relevant to the
Nigerian business environment and therefore can be used beneficially by analyst,
investor, Organization and government.

POLICY IMPLICATION

To improve stability in the productive industry and enhance capital formation, public
and private organizations should subject their annual reports to standard tests to be
sure their Organizations are in good health and the regulatory authorities should also
subject the institutions they supervise to regular analysis with standard BFP models to
be able to identify failing organization some years before the failure and intervene
early enough to save the economy the embarrassment of having banks with negative
assets of value running to billions of naira.

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