31st May,

2011

Term Paper

Financial Markets and Instruments

Predicting Bankruptcy through Financial Statement Analysis

Application of Altman Z-score Model and Logistic Regression Modeling to Analyze Publicly Held Banks in Bangladesh to Predict Bankruptcy

Prepared for: Mohammad SaifNoman Khan Assistant Professor, Institute of Business Administration, University of Dhaka.

Prepared by: Group 8 Omaer Ahmad, ZR-09 KawsarAhmad, ZR-50 RafaatWasik Ahmed, ZR-53 NasimUlHaque, ZR-54 Rashed Al Ahmed Tarique, ZR- 61 BBA 16th Batch, Institute of Business Administration, University of Dhaka.

Predicting Bankruptcy through Financial Statement Analysis

- Application of Altman Z-score Model and Logistic Regression Modellingto Analyze Publicly Held Banks in Bangladesh to Predict Bankruptcy

Team Leader: Rashed Al Ahmad Tarique Contact: e-mail: rtarique@gmail.com Mobile: 01671507262

Mohammad SaifNoman Khan Assistant Professor, Institute of Business Administration, University of Dhaka.

Dear Sir, We, Group 8, present to you our term paper for the course Financial Markets and Institutions. The title of our paper is Predicting Bankruptcy through Financial Statement Analysis. Along with this paper we provide you with a number of articles, spreadsheets and other documents to support our work. In this paper, we have studied models widely used over the world to predict bankruptcy in different sectors and have applied them to locally enlisted scheduled banks. This paper only derives its ideas from other researchers and hence is an original analysis. No works have been copied for its production. As we have not worked on the topic on any other course, this paper is exclusively for the purposes of this course. We will not, therefore, use any of its content without written permission from you. We have tried our best to abide by your guidelines in the preparation of this paper. For further inquiry about it, please feel free to contact us. Yours Sincerely,

Omaer Ahmad, ZR-09

Kawsar Ahmad, ZR-50

RafaatWasik Ahmed, ZR-53

NasimUlHaque, ZR-54

Rashed Al Ahmad Tarique, ZR-61 BBA 16th Batch, Institute of Business Administration, University of Dhaka 31st May, 2011.

Contents
Executive Summary .................................................................................................................... 4 Introduction ................................................................................................................................. 5 Literature Review ........................................................................................................................ 6 Financial Ratios as Predictors Failure ..................................................................................... 6 Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy............... 6 Step-Wise Multiple Discriminate Analysis ................................................................................ 7 On the Pricing of Corporate Debt: The Risk Structure of Interest Rates .................................. 7 Option-Based Bankruptcy Prediction ....................................................................................... 8 Bankruptcy Prediction for Credit Risk Using Neural Networks ................................................. 9 Bankruptcy Prediction of Turkish Commercial Banks Using Financial Ratios .......................... 9 Limitations & Scope .................................................................................................................. 10 Methodology ............................................................................................................................. 11 Altman z-score test................................................................................................................ 11 Logistic Regression Model (Logit model) ............................................................................... 13 Results ..................................................................................................................................... 15 Recommendations .................................................................................................................... 20 Bibliography .............................................................................................................................. 20

Table 1: Banks for the study ..................................................................................................... 11 Table 2: Ratios for the Logistic Regression Model .................................................................... 13 Table 3: Summarized z-scores for Banks.................................................................................. 15 Table 4:Summarized Bank Logit Score ..................................................................................... 18

Executive Summary
Banks are an integral part of everyday lives of people. Their importance is only increasing with every passing day. They are among the fastest growing corporations in the country. Hence, it is vital that such an arm of society does not come down and bring down with it the savings and livelihoods of a large chunk of the population. This report attempts to look at a number of tools which have been developed around the world in various spheres of industry. These include William H. Beavers t-tests, Edward Altmans zscore, Fulmans step-wise multiple discriminate analysis, Robert C. Mertons Merton model, Andreas Charitou and Lenos Trigeorgiss Options based bankruptcy prediction model, Amir F. Atiyas Neural Network based bankruptcy prediction model and finally logistic regression model by Birsen Eygi Erdogan. These bankruptcy prediction tools were developed as pre-warning systems to identify problematic organizations and provide a method to warn stakeholders at least a couple of years before to wake up and get their act together. We used annual report data from the enlisted banks on Dhaka Stock Exchange and used ratio analysis to get the variables that allowed us to run a couple of tests on them. These were the Altman z-score model and the Logistics Regression Model. These allowed us to identify corporations under threat. Of the banks analyzed First Security Islami Bank and Uttara Bank Limited were found to have problems that they need to address urgently. Another major finding of the report was that when these models were being developed in the western world, they encountered fewer instances of bankruptcy probability that here. This points out the excellent job that the Bangladesh Bank has been doing.

Introduction
Around the world, globalization of the marketplace is taking place. This has resulted from a deregulation of the markets. Banks now-a-days can delve into many spheres of business. Many industry experts reckon that this was one of the major reasons behind the financial crisis that rocked the world and from which we are still struggling to recover from. Numerous firms went bankrupt, taking with them many peoples entire lifes savings. Banks have become tied to every walk of life. It provides a liquidity to customers through a wide variety of services. It provides credit to entrepreneurs and home-buyers. It provides a means for building up a store of wealth for people through savings instruments for when they retire. So when a bank goes down, not only is the equity holder, the actual owner of the bank, affected, but everyone around them. Hence, it is crucial that early warning systems be in place so that these vital organs of society be able to offer their services in continuum. The regulatory body on banking in Bangladesh is Bangladesh Bank, the central bank. It has received plaudits from various corners of the globe for its role in effectively managing the banks in Bangladesh and not allowing them to fail. It has been vigilant in thinking on its feet and changing with the times and implementing new and effective measures whenever the need hasrisen for a change in regulations governing the banks to safeguard the money of the customers. The regulations set up by the central bank have been crucial to building the confidence of the general public in the banking system. The strict guidelines set by the Bank have allowed the banks to maintain their health and build themselves up. As a result, the banking industry is one of the fastest growing in the country. The purpose of this report is to test the fortitude of the banks towards staving off bankruptcy. We will look at a number of tools used to identify signs of possible bankruptcy on the horizon. We will apply these tools to analyze publicly available data on the banks and identify weaknesses or cracks, if any, in the banking sector. Finally we will attempt to come up with recommendations to plug the holes.

Literature Review
The study of bankruptcy extends to at least 1932.Paul J. FitzPatrick published a paper in The Certified Public Accountant on the topic.He used data for 20 matched pairs of firms and discussed accounting ratios as indicators of bankruptcy. This formed the basis for a much more thorough paper by William Beaver in 1968.

Financial Ratios as Predictors Failure

William H. Beavers paper named Financial Ratios as Predictors Failure(Beaver 1966), was the first truly credible paper on the topic. Financial ratios as a means of identifying the position and health of a firm and its credit worthiness had already been in practice by 1966.He aimed to identify the efficacy of these ratios as predictors of financial distress. For his study, he took paired sample of both failed and firms still in business to comparemeansusing t-tests.He then performed a dichotomousclassification test of likelihood ratios using the ratio of cash flow to total debt. He gleaned from the study Althoughratio analysis may provide useful information, it be used with discretion :(1) Not all ratios predict equally well. The cash-power throughoutflowto total-debt ratio has excellentdiscriminatory power in the five-yearperiod. However, the predictivepower of the liquid assetratios is much weaker. (2) The ratios do not predict failed and non-failed firms can be correctlyclassified to a greaterextentthan can failed firms.

Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy

Following Beavers work, Edward I. Altman from the Stern Business School of New York University wrote a paper on assessing the analytical quality of ratio analysis. Titled Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy (Altman Sep.,1968). Due to the relatively unsophisticated manner of traditional ratio analysis, it had lost its shine in academic spheres.In order to assess whether financial ratios were still up to the job, he combined a set of financial ratios in a discriminant analysis approach to the problem of corporate bankruptcy prediction. The theory is that ratios, if analyzed within a multivariate framework, will take on greater statistical significance than the common technique of sequential ratio comparisons. The discriminant-ratio model proved to be extremely accurate in predicting bankruptcy correctly in 94 per cent of the initial sample with 95 per cent of all firms in the bankrupt and non-bankrupt groups assigned to their actual group classification. Furthermore, the discriminant function was accurate in several secondary

samples introduced to test the reliability of the model. The model's

findings

were that

bankruptcy can be accurately predicted up to two years prior to actual failure with the accuracy diminishing rapidly after the second year. A limitation of the study was that the firms examined were all publicly held manufacturing corporations for which comprehensive financial data were obtainable, including market price quotations. Several practical and theoretical applications of the model were suggested. Among them were business credit evaluation, internal control procedures, and investment guidelines.

Step-Wise Multiple Discriminate Analysis

John G. Fulmer (Fulmer 1984) and his team used step-wise multiple discriminate analysis to evaluate 40 financial ratios applied to a sample of 60 companies -30 failed and 30 successful. This model was different as it focused on small firms. The average asset size of these firms was $455,000.Fulmer reported a 98% accuracy rate in classifying the test companies one year prior to failure and an 81% accuracy rate more than one year prior to bankruptcy. Another paper that looked into the topic was by James A. Ohlson (A.Ohlson, 1980). The major findings of the study can be summarized briefly. First, he identified four basic factors as being statistically significant in affecting the probability of failure (within one year). These are: (i) the size of the company; (ii) a measure(s) of the financial structure; (iii) a measure(s) of performance; (iv) a measure(s) of current liquidity. He conducted the study due to concern that, if one employs predictors derived from statements which were released after the date of bankruptcy, then the evidence indicates that it will be easier to "predict" bankruptcy. However, even if one allows for this factor, for the sample of firms used in this study, the prediction errorrate is larger in comparison to the rate reported in the original Altman [1968] study.He expressed that the previous models were relatively simple to apply and may be of use in practical applications. He stated that a potential disadvantage was that the model does not utilize any market transactions (price) data of the firms.

On the Pricing of Corporate Debt: The Risk Structure of Interest Rates

The Merton model is a model proposed by Robert C. Merton in 1974 for assessing the credit risk of a company by characterizing the company's equity as a call option on its assets. Put-call parity is then used to price the value of a put and this is treated as an analogous representation of the firm's credit risk. (Merton May 1974) The model takes three company specific inputs: the equity spot price, the equity volatility (which is transformed into asset volatility), and the

debt/share. The model also takes two inputs which should be calibrated to market quoted CDS spreads: the default barrier, and the volatility of the default barrier. These inputs are used to specify a diffusion process for the asset value. The entity is deemed to have defaulted when the asset value drops below the barrier. The barrier itself is stochastic, which has the effect of incorporating jump-to-default risk into the model. The Merton model evolves asset value movements through a diffusion process and a fundamental purpose of the default barrier volatility is to provide a jump-like process which can capture short term default probabilities.

Option-Based Bankruptcy Prediction

More recent approaches towards predicting bankruptcy include option valuation models for bankruptcy prediction. Some of the pioneers of this technique are Andreas Charitou and Lenos Trigeorgis. (Option-Based Bankruptcy Prediction, June 2000) Their study builds on and extends option-pricing theory to explain financial distressbased on a sample of 420 distressed U.S. firms for the period 1986-2001. Their results indicatethat the primary option variables, such as firm volatility, play an important role in explainingdistress up to five years prior to bankruptcy filing. When the model is extended to accountfor the probability of default on interest and debt repayments due at intermediate times priorto debt maturity (due to voluntary equityholder default or due to cash flow problems), anoption-motivated transformation of the cash flow coverage is shown to have incrementalexplanatory power, while the primary option variables remain statistically significant. The significant primary option variables include the face value of debtowed at maturity (lnB), the current market value of the firms assets (lnV), and the standard deviation ( ) of firm value changes (returns). The distance to default (d2d) and theprobability of default at maturity (-d2) were also found to be significant predictor variables. Despite the probability of intermediatedefault on due interest and debt repayments, the above primary option variables maintaintheir sign and significance. The latter results indicate that the extended option variablesbased on cash flow coverage have incremental explanatory power beyond the primary optionvariables. The latest models for bankruptcy prediction depend on neural network modeling. Artificial neural networks are composed of interconnecting artificial neurons (programming constructs that mimic the properties of biological neurons). Good performance (e.g. as measured by good predictive ability, low generalization error), or performance mimicking animal or human error patterns, can then be used as one source of evidence towards supporting the hypothesis that the abstraction really captured something important from the point of view of information processing in the

brain. Another incentive for these abstractions is to reduce the amount of computation required to simulate artificial neural networks, so as to allow one to experiment with larger networks and train them on larger data sets.Mathematically, a neuron's network function composition of other functions is defined as a , which can further be defined as a composition of other

functions. This can be conveniently represented as a network structure, with arrows depicting the dependencies between variables. What has attracted the most interest in neural networks is the possibility of learning. Given a specific task to solve, and a class of functions, means using a set of observationsto find , learning which solves the task in some optimal sense.

Bankruptcy Prediction for Credit Risk Using Neural Networks

Amir F. Atiya (Bankruptcy Prediction for Credit Risk Using Neural Networks: A Survey and New Results, JULY 2001) developed a model for predicting bankruptcy using Neural Networks. In the article he reviewed the problem of bankruptcy prediction using NNs.He found NNs generally superior to other techniques. Once that was established, the logical next step for the research community is to improve further the performance of NNs for this application, perhaps through better training methods, better architecture selection, or better inputs. It is this latter improvement aspect that he addressed in the second half ofthis paper. He proposed novel inputs extracted from the equity markets. His results showed new indicators which improve the prediction considerably, especially for long horizon forecast. This can be explained by the tendency ofthe equity markets to be highly predictive, not only of the healthof a firm, but also of the health of the economy, which in turnaffects the creditworthiness of the firm.

Bankruptcy Prediction of Turkish Commercial Banks Using Financial Ratios

In his paper Bankruptcy Prediction of Turkish Commercial Banks Using Financial Ratios, (Erdogan 2008) Birsen Eygi Erdogan uses data compiled from the years 1997 and 1999. Logistic Regression was used to form a prediction model with nancial ratios. 42 commercial banks were included in this research. It was observed that 80% of failed banks could be predicted two years a priori, and Logistic Regression can be used as a part of an early warning system. In this research, in order to determine the statistically signicant ratios many suggested methods were used, such as Single Logistic Regression, Multivariate Variable Selection Procedure, All Possible Regression, Forward and Backward Elimination methods. 20 nancial ratios were examined for each year for the 1997 -1999 periods. After using Factor Analysis, the forward logistic regression and backward elimination methods were applied, and di erent combinations of the ratios were tested. The selection of the nal ratios was based on the

statistical signicance (at 10% level) of the estimated parameters and the model classication results. Logistic Regression is a method coming from statistics whose objective is to obtain a functional relationship between a transformation from a qualitative variable called logit and predictor variables which can be either quantitative or qualitative. Where B(X) is a classication model, the Logistic Regression model is described by the following formula: Prob(X) = 1/(1+e(B(X)) It is used to classify new individuals starting from rules in the following way: If Prob(x) < c then individual is classied as 0, otherwise it is classied as 1. c is the cut-off point. The cut-off point or level of probability that is used to categorize a bank as failed is usually chosen as 0.5 in literature. In this research bankrupt banks were classified as 0 and successful banks were classified as 1. Cut off point was chosen as 0.5. Those under 0.5 were classified as 0 and above 0.5 as 1. In some studies it is noted that classifying a failed bank as a non-failed bank can have more severe consequences than classifying a non-failed bank as a failed bank. It was observed that from predictions made by the study, 18 banks were predicted to fail over the coming two years. Of these all were predicted successfully.

Limitations & Scope

In this report, we will analyze bankruptcy probability only among the enlisted banks on Dhaka Stock Exchange. Information only available from the financial statements of these companies would be used to find out the ratios used for the report. Therefore, only the methods that use financial ratios to predict bankruptcy of firms. The lack of cases of bank failure in the country (due to vigilance of the central bank) means the sample for testing these models is very low. Therefore, this study will only apply the established tools used elsewhere and not test them.

Methodology
The report will use the annual reports of the enlisted banks on Dhaka Stock Exchange. We will apply the Altman z-score test and the Logistic Regression model. The banks that were considered were:

Table 1: Banks for the study

ABBANK ALARABANK BANKASIA BRACBANK CITYBANK DHAKABANK

EBL EXIMBANK FIRSTSBANK ISLAMIBANK ICBIBANK IFIC

JAMUNABANK MERCANBANK MTBL NBL NCCBANK ONEBANKLTD

PREMIERBAN PRIMEBANK PUBALIBANK RUPALIBANK SOUTHEASTB SIBL

SHAHJABANK STANDBANKL TRUSTBANK UCBL UTTARABANK

Altman z-score test

The Multi Discriminant Analysis narrows down multiple variables into a single dimension. This single dimension is the z-score. The z-score model is defined as: Z=V1X1+V2X2++VnXn Where V1, V2.. are the discriminant coefficients and X1,X2 are the actual values of the financial ratios. Of the 22 variables initially selected, five were identified to have the greatest significance in predicting bankruptcy. These variables were: X1= (Working Capital/Total Assets) X2= (Retained Earnings/Total Assets) X3= (EBT/Total Assets)

X4= (MV of Equity/Total Liabilities) X5= (Interest Income/Total Assets) Using MDA for the banking sector, the values obtained for the discriminants were: V1=1.2 V2=1.4 V3=3.3 V4=0.6 V5=1.0 Using the spreadsheets titled Altman z-score we find the relevant z-scores for the banks analyzed by using the following equation: Z= 1.2*X1+1.4* X2+3.3* X3+0.6*X4+1.0* X5 According to Altman, the z-score boundaries that we should look for are: Z3 The company will continue to thrive 1.8Z2.7 The company is in a grey area. The firm should be kept under strict management scrutiny Z1.8 The company is highly likely to go bankrupt in the next three years.

Logistic Regression Model (Logit model)

The ratios that were considered in the study included:
Table 2: Ratios for the Logistic Regression Model

The ratios that were found to be statistically significant are: C2 = (Shareholders Equity + Total Income)/ (Deposits + Non-deposit Funds)

C12 = Net Income (Loss)/ Average Total Assets C14 = Net Income (Loss)/ Average Share-in Capital C16 = Interest Income/ Interest Expenses C17 = Non-Interest Income/ Non-Interest Expenses C19 = Provision for Loan Losses/ Total Loans Using these ratios, the following equation was developed using the logit analysis: XB = -13,20738+ 626098xC2-2,169955xC12+ 9,429545E-02xC14+ 5,528393E02xC16+2,361215E-02xC17-1,704793xC19 Where XB refers to the expectation of bankruptcy and the coefficients are obtained through logit analysis.

Results
The ratings found from the Altman z-score analysis for the banks are:
Table 3: Summarized z-scores for Banks

Bank(in Alphabetical Order)

Zscore 3.0 2.5 4.3 4.2 4.9 4.9 5.6 4.7 2.3 3.7 7.8 5.6 3.6 4.2 4.2

Prediction

ABBANK

Will survive Needs careful management Will survive Will survive Will survive Will survive Will survive Will survive Needs careful management Will survive Will survive Will survive Will survive Will survive Will survive

ALARABANK

BANKASIA BRACBANK CITYBANK DHAKABANK EBL EXIMBANK

FIRSTSBANK

ISLAMIBANK ICBIBANK IFIC JAMUNABANK MERCANBANK MTBL

NBL NCCBANK ONEBANKLTD PREMIERBAN PRIMEBANK PUBALIBANK

7.7 7.2 4.8 3.5 6.2 5.6 2.5 4.8 3.7 5.2 4.6 4.5 3.7 1.8

Will survive Will survive Will survive Will survive Will survive Will survive Needs careful management Will survive Will survive Will survive Will survive Will survive Will survive Needs careful management

RUPALIBANK

SOUTHEASTB SIBL SHAHJABANK STANDBANKL TRUSTBANK UCBL

UTTARABANK

It can be observed that none of the banks in the study are predicted to run into financial distress in the upcoming two years. However, Uttara Bank is on the brink and First Security Islami Bank is following suit. This can be stated with an error of 5%.

The following table shows condensed results of the logistical regression analysis run on the banks:

Table 4:Summarized Bank Logit Score

Success XB Prob(Y=1) C=0.8 ABBANK ALARABANK BANKASIA BRACBANK CITYBANK DHAKABANK EBL EXIMBANK FIRSTSBANK ISLAMIBANK ICBIBANK IFIC JAMUNABANK MERCANBANK MTBL NBL NCCBANK 2.60350284 1.914949135 2.481710771 2.368667275 2.344648753 2.287322983 1.925777817 1.649473182 -0.129509725 1.905841949 3.32887004 2.590530777 1.81528443 1.948493876 1.743904699 2.940085608 2.206194565 0.93109 0.87157 0.92285 0.91441 0.91251 0.90782 0.87278 0.83882 0.46767 0.87055 0.96541 0.93025 0.86000 0.87528 0.85118 0.94979 0.90080 1 1 1 1 1 1 1 1 0 1 1 1 1 1 1 1 1

ONEBANKLTD PREMIERBAN PRIMEBANK PUBALIBANK RUPALIBANK SOUTHEASTB SIBL SHAHJABANK STANDBANKL TRUSTBANK UCBL UTTARABANK

2.3020672 2.977622628 3.880745967 1.083317134 1.499605496 2.132822901 1.452824034 2.869738662 2.015806192 2.39490092 2.427403216 1.228150789

0.90905 0.95155 0.97978 0.74712 0.81752 0.89405 0.81043 0.94633 0.88245 0.91644 0.91889 0.77349

1 1 1 0 1 1 1 1 1 1 1 0

From the above table the only bank found likely to fail in the next two years is First Security Islami Bank if we use a cut-off point of 0.8, as prescribed for developing economies. If we combine the findings of the two analysis we arrive at a number of conclusions. First, when utilizing models developed in developed economies we observe that the probability of failure among local banks are very low. This clearly refers to the great job done by the Central Bank in managing the private banking sector in Banlgadesh. The second conclusion that can be derived from the results is that a couple of banks First Security Islami Bank and Uttara Bank - have performed sorrily on both counts. Careful management of the firms asset quality, gapping strategies, cash management and provisions made for bad loans, cost cutting in non-interest earning fields will be needed to nurse these banking businesses.

Recommendations
Further study with data available outside the financial statements needs to be undertaken. All the models described need to undergo tests. A more rigorous study needs to be undertaken to find the validity of these models in predicting failures in the sector. This will help in the ultimate goal which is to develop a thorough holistic model that will avert danger in the sector.

Bibliography
A.Ohlson, James. "Financial Ratios and the Probabilistic Prediction of Bankruptcy." Journal of Accounting Research, Vol. 18, No. 1, (Spring, 1980: 109-131. Altman, Edward I. "Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy." The Journal of Finance, Vol.23, No.4. , Sep.,1968: 589-609. "Bankruptcy Prediction for Credit Risk Using Neural Networks: A Survey and New Results." IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 12, NO. 4, JULY 2001: 929-936. Beaver, William H. "Financial Ratios as Predictors of Failure." Journal of Accounting Research, 1966: 71-111. Erdogan, Birsen Eygi. "Bankruptcy Prediction of Turkish Commercial Banks Using Financial Ratios." Applied Mathematical Sciences,Vol.2,no.60,2973-2982, 2008. Fulmer, John G. Jr., Moon, James E., Gavin, Thomas A., Erwin, Michael J. "A Bankruptcy Classification Model For Small Firms." Journal of Commercial Bank Lending, 1984: 25-37. Merton, Robert C. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates." The Journal of Finance, Vol. 29, No. 2, May 1974: 449-470. Trigeorgis, Andreas Charitou and Lenos. "Option-Based Bankruptcy Prediction." European Financial Management Journal, June 2000.