Validation and Re-Estimation of Altman’s Z″-Score Model for Financial Distress Prediction in Financial Institutions of Pakistan

Abstract

Financial problems forecasting plays an important role in financial management and, especially, in economies that rely on their stability to grow financially. The base of any economy comprises the following types of financial entities: banks, insurance firms, and development finance organizations. In Pakistan, these entities play a significant role in economic development due to financial activities conducted by them through investment, lending, and financial interpretation. Nevertheless, severe economic consequences may occur because of financial instability in these companies. The Altman Z-Score model, which was designed back in 1968, is one of the most common models that predict the financial crisis. This particular method measures the probability of bankruptcy through the use of financial ratios. Z' and Z'-Score models were developed throughout time as improvements to increase their applicability in different environments such as non-manufacturing organizations and those in the developing markets. Financial organizations have a unique characteristic that sets them aside from other non-financial organizations, even though this model is commonly used. First of all, the financial sector depends on deposits and financial instruments and does not depend on assets. Additionally, these firms are subject to special regulatory systems while maintaining high degrees of leverage. Such characteristics make it uncertain whether the Altman Z-Score model is applicable to predict a financial crisis in such organizations, especially in countries like Pakistan. The Altman Z-Score model, which was designed back in 1968, is one of the most common models that predict the financial crisis. This particular method measures the probability of bankruptcy through the use of financial ratios. The financial institutions depend more on the deposits and the financial instruments than on the tangible assets, work within specialized regulatory structures, and have significant leverage. Such differences raise doubts about the applicability of the Altman’s Z-Score approach in forecasting financial troubles in such entities, particularly in developing countries such as Pakistan. The financial sector of Pakistan has faced various issues such as the rise of non-performing loans, liquidity constraints, and changes in policies. However, very little research exists regarding the effectiveness of the financial distress prediction model in the financial institutions of Pakistan. Such a vacuum has been created in practical and theoretical fields alike.