L.C. Gupta Model is another model of understanding Financial Distress. This model made an attempt to examine survival strength of the company derived from the concept of marginal firms. This study is based in Indian data, attempting to distinguish sick and non-sick companies on the basis of financial ratios.
The sample taken was of 41 cotton textile companies (20 sick and 21 non-sick) and 39 non-textile companies (18 sick and 21 non-sick) and both type of companies were matched on the basis of product manufactured, age and size measured in terms of paid-up capital, assets and sales for the period of 1962-1974. This model tested 56 financial ratio for making the prediction of distress.
L.C. Gupta Model Analysis
- Take a sample of Sick and Non-Sick companies.
- Arrange them in the ascending or descending order by the magnitude of the ratio.
- Select a cut-off point carefully which will divide the array into two classes with a minimum possible number of misclassification.
- Compute the percentage of classification error.
- The ratio which shows the least “percentage classification error” at the earliest possible time is deemed to have the highest predictive power.
The model recommended a combination of the following four major ratios in order to minimize the classification error rate:
- X1 = 𝑬𝑩𝑫𝑰𝑻 𝑺𝒂𝒍𝒆𝒔
- X2 = 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘 𝑺𝒂𝒍𝒆𝒔
- X3 = 𝑬𝑩𝑫𝑰𝑻 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕
- X4 = 𝑬𝑩𝑫𝑰𝑻 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕+𝟎.𝟐𝟓 𝑫𝒆𝒃𝒕
L.C. Gupta Model Observation
- The net worth ratio are the worst predictor of bankruptcy among profitability ratios.
- Among balance sheet ratios, the solvency ratios were more reliable indicators of strength than any liquidity ratios.
- The model also observed that companies with an inadequate equity base are more sickness prone.