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The origins of the Health Score

Dr Merv Lincoln’s Financial Health methodology developed models from accounting ratios and characterised the financial standing of a company using a single figure on a scale of risk from 0.01 to 1, with the company’s level of Financial Health deteriorating as the measure moves towards 1. On the scale of Financial Health, for ease of interpretation, the following benchmarks are used:

0.01 - 0.10 = Strong
0.11 - 0.30 = Satisfactory
0.31 - 0.50 = Early Warning
0.51 - 0.80 = Marginal
0.81 - 1.00 = Distress

If a company has a Strong or Satisfactory financial standing it will be interpreted as having a balance sheet with borrowing capacity to finance growth.

If a company is in the zone of Early Warning it is neither satisfactory nor particularly unhealthy. The company will need to address certain issues in regards to its business operations in order to achieve a healthy financial position.

A Marginal financial standing indicates risk above desired levels. Hard decisions are required by management to get the company back into better shape. The decisions required would be detailed. A critical factor here is assessment of the ability of management to reverse the decisions that led to the precarious financial standing.

If the company is in Distress it is exhibiting the financial characteristics of failing companies. It will be difficult for this company to recover and any recovery will generally be slow as it tends to take longer to get out of a difficult situation than it does to get into one.

A further aim is to analyse the trends in the computed Financial Health measurements to assist in the development of a theory of corporate financial distress: its causes, symptoms and remedies. The appropriate comments from the theory appear in the analysis of a company.

The calculation of ratios from financial statements is commonly used to determine the financial status of a company. The traditional univariate approach can provide potentially confusing results, as different ratios can imply different predictions for the same company. Dr Lincoln's methodology used a multivariate approach as a means of overcoming potential confusion in assessing results.

The multivariate approach combines and weights several key ratios to obtain a score which is assigned a Financial Health rating from a table relating scores to various levels of Financial Health.

In Dr Lincoln's study, models were constructed using companies; both those that had failed and those that had survived during the period 1969 to 1978. Using a sample of failed and non-failed companies, a set of financial ratios were selected which yielded a linear function of ratios making the best distinction between the two groups. It was necessary to acknowledge that the financial characteristics of industries differ and models were constructed for different industry groups.

Recognising the changes in the economic landscape, accounting methods and reporting standards, Lincoln undertook further research in 2007 to refine its unique methodology. Under the guidance and supervision of esteemed academic Associate Professor Neville Norman of the University of Melbourne, the model was revisited and new ratios were tested using multi level modelling with the aim of improving its predictive power.