Financial Characteristics of Distressed Firms: An Application of the Altman Algorithm Model

• Author: Karikari Amoa‐Gyarteng
• DOI: http://doi.org/10.1002/jcaf.22367
• Date: 01 January 2019
• Published date: 01 January 2019

Financial Characteristics

of Distressed Firms: An

Application of the Altman

Algorithm Model

Karikari Amoa-Gyarteng

INTRODUCTION

Financial distre ss

is the situation where

afirm is incapable of

meeting financial

obligations (Brealey,

Myers, & Marcus,

2009). When firms

default, creditors may

take over through a

legal mechanism

referred to as bank-

ruptcy (Brealey et al.,

2009). Bankruptcy

has become a vital

subject in corporate

finance because of the

Global Financial Cri-

ses of 2007 and 2008

(Avenhuis, 2013).

According to Steyn-

Bruwer and Hamman (2006),

firms may file for bankruptcy

when they are in financial dis-

tress and cannot continue to

exist in their original forms.

Bankruptcy may lead to

either liquidation or reorgani-

zation (Bernstein, Colonnelli,

Giroud, & Iverson, 2017). In

the United States, firms that

seek to reorganize may file

for Chapter 11

bankruptcy (Bracewell

& Giuliani, 2012).

Firms that seek to liq-

uidate, file for Chap-

ter 7 bankruptcy.

Chapter 7 bankruptcy

may be voluntary or

enforced by creditors.

Reasons for cor-

porate financial dis-

tress are manifold.

They include manage-

rial incompetence

(Aasen, 2011), illi-

quidity (Pruitt &

Gitman, 1991), over

leverage (Andrade &

Kaplan, 1998), and

low profitability

(Altman, 2000).

External factors as

explained by Altman and

Hotchkiss (2006) may also

cause financial distress. They

include deregulation of indus-

tries, industry saturation leading

This article uses the discrete variables in the

Altman algorithm model to describe the charac-

teristics of firmsastheyapproachbankruptcy.

Data are drawn from 144 mining and oil and

gas firms that declared Chapter 11 and Chap-

ter 7 bankruptcy in the United States between

2006 and 2016. Part of the population eligibility

criteria for the study is that firms should be

publicly traded and should have filed form 10-K

reports with the Securities and Exchange Com-

mission. A paired samples t-test shows that

the Altman Zscore, solvency, profitability, and

asset productivity become statistically signifi-

cantly worse when bankruptcy becomes immi-

nent. The article further finds that there is no

statistically significant change in liquidity and

activity ratios of distressed firms as financial

performance deteriorates. © 2019 Wiley Periodicals, Inc.

© 2019 Wiley Periodicals, Inc.

Published online in Wiley Online Library (wileyonlinelibrary.com).

DOI 10.1002/jcaf.22367 63