Part 3 - Business failure

Question 1

Business failure

Answer 1

• Z-scores is a quantitative model based around a number of financial indicators
• Argenti’s A-score model is a qualitative model which assesses defects, mistakes and symptoms of decline within an organisation.

Question 2

The appropriateness of Z-scores

Answer 2

• Financial ratios which significantly differ in value between surviving and failing companies.
• The weightings for these ratios in a formula for a score which can be used to identify companies which exhibit the features of previously failing companies

Question 3

Inappropriateness of Z-scores: Z-score was originally developed in the late 1960s and was based on data from US companies

Answer 3

• The world economy has changed significantly since Altman’s original work. The data for this model is now nearly 50 years old.
• The economy of the USA may not reflect the market in which Culam works.
• The mining sector is not like general manufacturing, for example, it is highly capital intensive with long periods of no revenue generation.

Question 4

The Q-score model was based on recent data from Teeland businesses

Answer 4

• The Q-score is based on data for Teeland listed companies and Culam is a mining company with an unusual pattern of revenue and costs supplying a global market => unsimilar
• If Teeland’s exchange is small, there may not be much data from failing companies on which to base the model.

Question 5

The usefulness of the quantitative K Score model

Answer 5

Ad:

• Calculated easily from readily available financial data
• No subjectivity required in calculating the score which can be easily compared

Dis:

• Uses historical data
• Data may be unavailable or unreliable
• K Scores of between 2 and 5 lie in the ‘grey area’, where further analysis is needed in order to reach a clear conclusion.
• it does not give any suggestions on how to reduce the likelihood of corporate failure.

Question 6

Operational gearing

Answer 6

Operational gearing indicates the level of business risk which companies face by measuring the relative amount of fixed costs.

Question 7

Financial gearing

Answer 7

The financial gearing ratio measures financial risk and reflects the company’s ability to service its long-term debt.

Question 8

What is A-Score

Answer 8

The Argenti A Score assigns scores to management defects and accounting defects, which are effectively weaknesses which can lead to failure, mistakes, and symptoms.

Question 9

Advantages of using qualitative models

Answer 9

• The subjectivity of the A Score => allows the person calculating the A Score to use their own professional judgement in considering individual circumstances.
• It also recognises factors which have been observed in failing companies
• The A Score model incorporates financial (such as the operating gearing ratio), and non-financial factors, which give a more holistic assessment

Question 10

Disadvantages of using qualitative models in predicting corporate failure

Answer 10

• Calculating the A Score is subjective and requires experience and professional judgement,=> difficult to compare the score between organisations.
• The A Score focuses on internal factors, which limits its usefulness.
• A limitation of the A Score model is that it is only a snapshot at a particular time and does not indicate when corporate failure may occur.
• The fact that the A Score does not give a definitive indication of whether failure will happen may mean inappropriate decisions are taken as a result of the analysis.

Question 11

Defects:

Answer 11

+ Autocratic Chief Executives
+ Passive board, weak financial directors
+ Poor respond to changes
+ Lack of budgetary control, cashflow forecash, costing system

Question 12

• Mistakes

Answer 12

+ Over-trading
+ Gearning
+ Failure of large project jeopardize the company

Question 13

• Symptoms

Answer 13

+ Deteriorating ratios
+ Creative accounting
+ Declining moral or declining quality