Evaluation of Applicability of Altman's Revised Model in Prediction of Financial Distress in Kenya

Abstract

Edward Altman's financial distress prediction model is a linear analysis in that five measures are objectively weighted and summed up to arrive at an overall score that then becomes the basis for classification of firms into one of the a priori groupings (distressed and non-distressed).

The objective of this study was to assess whether Edward Altman's financial distress prediction model can apply locally. This study used a descriptive survey design. The study population of this study was all the companies listed in the Nairobi Stock exchange in 1989 to 2008. The sample size of this study was 10 firms listed and 10 firms delisted in Nairobi stock exchange 1989 to 2008. Secondary data was obtained from financial reports of the listed companies at the Nairobi Stock Exchange and the Capital Markets Authority.

This research study revealed that Edward Altman's financial distress prediction model was applicable locally. Edward Altman's financial distress prediction model was found to be applicable in 6 out of the 10 failed firms that were analyzed, which indicates a 60% validity of the model. Out of the 10 firms which had not failed that were analyzed, 8 of them proved that Edward Altman's financial distress prediction model was applicable locally indicating an 80% validity of the model. This gives an aggregate average of70% validity of the model.

This study therefore recommends that studies should be done on how to eliminate the type I and type II errors. The study also recommends that firms in Kenya should be using Altman's business failure prediction model annually in order to predict whether there is a possibility of failing.