In this series of posts we’re exploring some of the alternatives to the 45 year old Altman Z-Score for successfully predicting bankruptcies. So far we’ve looked at the 2010 CHS model which is generally regarded as the best all-round replacement. Today we’re going to take a look at the 1980 Ohlson O-score, followed by the 1974 Merton ‘Distance-to-Default’ (DD) method in the third and final instalment. The O-score is still heavily referenced in academic literature and has its place in the arsenal of analysts around the world. All together it sounded like it was worth taking a closer look at.
Similar to the Z-score, the O-score can be described as a statistical bankruptcy indicator generated from a set of balance sheet ratios. Where it differs from Altman’s original is in its application of a much larger sample of corporate successes and failures to inform the model. The wider pool of just over 2000 companies gives it a more robust sample for basing the scaling factors applied to its nine variables with the aim of increasing its accuracy. The difference in this sample size is especially apparent when compared to Altman’s original whose statistical technique of pair matching limited him to just 66 companies (it’s amazing it’s still as successful as it is!). Subsequent studies have generally found the O-score to be a better forecaster of bankruptcy than the Z-score, however neither has been able to regularly beat Merton’s DD or the CHS model since their discoveries.
How It Works
To begin with, let’s take a look at each of the variables and think about why they’ve been included.
- Adjusted Size: Ohlson measures a company’s size as its total assets adjusted for inflation. Smaller companies are deemed to be more at risk of failure.
- AS = log(Total assets/GNP price-level index)
- Where GNP price-level index = (Nominal GNP/Real GNP)*100
- Leverage Measure: Designed to capture the indebtedness of a company, the more leveraged the more at risk the company is to shocks.
- LM = Total liabilities/Total assets
- Working Capital Measure: Even if a company is endowed with assets and profitability, it must have sufficient liquidity to service short-term debt and upcoming operational expenses to avoid going bust.
- WCM = Working capital/Total Assets
- Inverse Current Ratio: This is another measure of a company’s liquidity.
- ICR = Current liabilities/Current assets
- Discontinuity Correction for Leverage Measure: Dummy variable equalling one if total liabilities exceeds total assets, zero otherwise. Negative book value in…