124 Corporate Finance
A high Z score represents a low probability of default and a low Z score represents a high probability
of default. The model’s classification accuracy was 95 percent one year before bankruptcy, and 72 percent
two years before that. Accuracy of the model decreases as the time period is extended (it may also be un-
reliable in its predictive ability). Based on the study, it was concluded that firms with a Z score less than
1.81 are all bankrupt, while those with Z scores greater than 2.99 fall into the non-bankrupt group. Those
falling into the area between 1.81 and 2.99 require more analysis to determine their solvency status. The
non-liquid asset ratios like total debt to total assets and cash flow to total debt are, in general, better predictors
of bankruptcy than the liquid assets ratios like quick ratio or net working capital to total assets.
Managers may use distress prediction models as a first step to understand the solvency status of their
firms. A low Z score (below 1.81) itself does not suggest that bankruptcy will occur. A firm may avoid
bankruptcy by cash infusion and/or waiving of loan covenants by lenders.
Funds Flow Statement
A balance sheet gives us the snapshot of the financial condition of a firm measured on a particular date (say
financial closing date). It is a stock concept. An income statement, on the other hand, is a flow concept. It
tells us how the owners’ equity changed during the accounting year. A third statement, called the funds flow
statement, shows the sources from which funds were raised between two balance sheet dates and how they
were deployed. Funds flow statement is also called statement of changes in financial position. It enables us
to answer such questions as:
- How did the firm finance capital expenditure? Was it by way of equity or debt or some combination?
- How is the firm financing its dividend payments? How was it possible to distribute dividends in excess
of profits for the current year? - Is the company building up or slashing down inventory?
Preparation of Funds Flow Statement
All increases in liabilities and decreases in assets are sources of funds and all decreases in liabilities and
increases in assets are uses (application) of funds. Source of funds will always be equal to uses of funds. To
prepare a funds flow statement, place two balance sheets of two dates side by side and note down all changes.
Then segregate them into sources and uses of funds.
The sources of funds are:
- Net income
- Funds from depreciation
- Issue of capital stock in cash
- Term loans from FIs, proceeds from selling debentures, public deposits
- Sale of fixed assets and investments
- Reduction in other assets (current and non-current)
- Decrease in marketable securities
- Increase in notes/accounts payable/deferred tax/employee benefits/deferred credits