Summary
Although copious statistical failure prediction models are described in the literature, appropriate tests of whether such methodologies really work in practice are lacking. Validation exercises typically use small samples of non-failed firms and are not true tests of ex ante predictive ability, the key issue of relevance to model users. This paper provides the operating characteristics of the well-known Taffler (1983) UK-based z-score model for the first time and evaluates its performance over the 25-year period since it was originally developed. The model is shown to have clear predictive ability over this extended time period and dominates more naïve prediction approaches. This study also illustrates the economic value to a bank of using such methodologies for default risk assessment purposes. Prima facie, such results also demonstrate the predictive ability of the published accounting numbers and associated financial ratios used in the z-score model calculation.
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Twenty-Five Years of the Taffler Z-Score Model: Does It Really Have Predictive Ability?
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1. IntroductionThere is renewed interest in credit risk assessment methods following Basel II and recent high profile failures such as Enron and Worldcom. New approaches are continuously being proposed (e.g. Hillegeist et al., 2004; Vassalou and Xing, 2004; Bharath and Shumway, 2004) and academic journals publish special issues on the topic (e.g. Journal of Banking and Finance, 2001). The traditional z-score technique for measuring corporate financial distress, however, is still a well-accepted tool for practical financial analysis. It is discussed in detail in most of the standard texts and continues to be widely used both in academic literature and by practitioners.The z-score is used as a proxy for bankruptcy risk in exploring such areas as merger and divestment activity (e.g. Shrieves and Stevens, 1979; Lasfer et al., 1996; Sudarsanam and Lai, 2001), asset pricing and market efficiency (e.g. Altman and Brenner, 1981; Katz et al., 1985; Dichev, 1998; Griffin and Lemmon, 2002; Ferguson and Shockley, 2003), capital structure determination (e.g. Wald, 1999; Graham, 2000; Allayannis et al., 2003; Molina, 2005), the pricing of credit risk (see Kao, 2000 for an overview), distressed securities (e.g. Altman, 2002: ch. 22; Marchesini et al., 2004), and bond ratings and portfolios (e.g. Altman, 1993: ch. 10; Caouette et al., 1998: ch. 19). Z-score models are also extensively used as a tool in assessing firm financial health in going-concern research (e.g. Citron and Taffler, 1992, 2001 and 2004; Carcello et al., 1995; Mutchler et al., 1997; Louwers, 1998; Taffler et al., 2004).Interestingly, despite the widespread use of the z-score approach, no study to our knowled...See the full content of this document
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