The Argenti Model and Qualitative Failure Prediction: Scoring, Strengths and Limits

Many companies that fail are not caught out by a single bad year. They are run for years by a chief executive who is also the chairman, with a board that never questions him, a finance department that cannot produce a cash flow forecast and no real budgetary control.

Then the company takes on a project that is too big for it, borrows heavily to pay for it, and only then do the ratios turn bad. If the people who lend to it, supply it or work for it had looked at how it was managed instead of at last year’s accounts, they would have seen the danger five years earlier.

John Argenti built a model on this idea. His A-score is a way of giving a number to the weaknesses in management and control that precede failure. This topic explains the model, how to score a company, how to interpret the score, and the strengths and limits of qualitative models compared with quantitative ones such as the Z-score.

It builds on the earlier topic on social and ethical issues in strategy, which introduced corporate governance. The next topic covers preventing corporate failure and performance improvement strategies.

The Argenti model

The A-score rests on the view that corporate failure follows a predictable sequence, which may take five years or more:

1. Defects in management and in accounting information systems.
2. Mistakes that weak management is bound to make in time.
3. Symptoms of failure that finally become visible in the accounts and in behaviour.

Each item is given its mark if the weakness is present and zero if it is not. The marks are added within each group and then overall. The scoring is by judgement, so examination questions give the marks to use. The usual published marks are as follows.

Defects (management weaknesses and accounting deficiencies)

• Management weaknesses: an autocratic chief executive, 8; a chief executive who is also chairman, 4; a passive board, 2; unbalanced skills on the board, 2; a weak finance director, 2; lack of management depth, 1; and poor response to change, 15.
• Accounting deficiencies: no budgetary control, 3; no cash flow plans, 3; no costing system, 3.

The maximum for defects is about 45 marks in published versions, and Argenti suggests that a score of 10 or less is satisfactory. More than that points to weak management.

Mistakes

If management is weak it will make mistakes, which may not show for a long time. Three are scored 15 each, a maximum of 45: high gearing (more borrowing than the business can service), overtrading (growing sales faster than the business has capital to support, which strains working capital and cash) and a big project that is large enough to bring the company down if it goes wrong. A score below 15 is regarded as satisfactory.

Symptoms

Symptoms come last and carry a maximum of 12 marks, in four groups:

• Financial signs (4): falling profitability, liquidity and solvency ratios, and rising gearing.
• Creative accounting (4): the use of accounting policies and arrangements to hide the problems, such as changing depreciation, capitalising costs or window-dressing.
• Non-financial signs (3): frozen management salaries, delayed capital expenditure, falling market share, rising staff turnover, deteriorating quality.
• Terminal signs (1): at the end, the signs are so obvious that anyone can see them: falling sales, loss of market share, rising costs, and cash that has run out.

The overall score

The overall pass mark is 25. A company that scores above it shows many of the signs that come before failure and should cause concern. Below 25 the sub-scores still matter: a defects score above 10 may be a warning, and so may a high mistakes score, because weak management that has not yet failed is still weak management.

Qualitative and quantitative models compared

Failure can be assessed with quantitative measures (profitability, liquidity and solvency ratios and models such as the Z-score) and with qualitative measures (management quality, information flow, accounting practices, shareholder and debt behaviour, and non-financial signs). External factors such as an economic downturn, adverse industry trends and changes in consumer behaviour also matter.

Strengths of the Argenti model

• It looks at causes, not only outcomes, so it can give an early warning years before the ratios deteriorate.
• It covers management quality and governance, which accounts do not show.
• It combines accounting and non-accounting signs and is simple to apply.
• Its sub-scores show where the weakness lies, which helps in choosing a remedy.
• It is useful for small and private companies for which market data does not exist.

Limitations of the Argenti model

• The scoring is subjective: two analysts may mark the same board differently.
• Much of the information, such as how the chief executive behaves, cannot be seen by outsiders, so lenders and analysts must guess.
• The marks and pass mark are arbitrary and have not been shown to predict failure reliably.
• It gives a snapshot and does not say when failure may occur.
• It does not account for industry differences or for the economic setting.
• A well-managed company may still fail through an external shock.

Quantitative models

Quantitative models are objective, use published figures, can be calculated for many companies at once and can be tracked over time. They are backward-looking, depend on accounting policies that can be manipulated, ignore management quality and governance, and may give false alarms or miss a failure. The best practice is to use both kinds: the numbers show the position and the qualitative review shows the reasons.

Scoring a company

1. For each item in the scoring table, write its mark if the weakness is present and zero if not.
2. Add the defects, add the mistakes and add the symptoms.
3. Add the three groups for the overall score.
4. Compare: defects against 10, mistakes against 15, overall against 25.
5. Comment on which group is the main concern and what should be done.

Use the marks given in the question. Where none are given, state the published marks you are using.

Worked examples

1. Defects. Autocratic chief executive 8; chief executive also chairman 4; weak finance director 2; no budgetary control 3 = 17. Above the satisfactory level of 10.
2. Mistakes. High gearing 15. At the limit of the satisfactory level of 15.
3. Symptoms.
   Financial signs 4 + non-financial signs 3 = 7.
4. Total.
   17 + 15 + 7 = 39, well above the pass mark of 25.
5. Conclusion. The company shows many of the signs that come before failure. The main problem is governance: one person holds both roles and nobody challenges him. The first steps are to separate chairman from chief executive, to strengthen the finance function, to introduce budgetary control and to cut gearing.

1. Defects. Autocratic chief executive only: 8, now satisfactory.
2. Mistakes. None: 0.
3. Symptoms. Financial signs: 4.
4. Total.
   8 + 0 + 4 = 12, below 25.
5. Conclusion. The score has fallen from 39 to 12. The company is out of the danger zone but the autocratic chief executive, which carries the largest single defect mark, remains and should be addressed, for example by succession planning and a stronger board.

Expect variants: a scenario that you must turn into the items, a different set of marks, a company that scores below 25 overall but above the limit in one group, or a request to compare the result with a Z-score.

Common mistakes

• Scoring items that are not present. Give a mark only if the weakness is shown in the facts.
• Mixing up the groups. Gearing is a mistake, creative accounting is a symptom, an autocratic chief executive is a defect.
• Looking only at the total. Check each group against its own limit.
• Calling the model a ratio model. It is qualitative.
• Presenting the score as a forecast of failure. It signals risk.
• No advice. Say what management should do.

Quick revision

• Sequence: defects, mistakes, symptoms, over years.
• Defects about 45 marks (10 or less satisfactory); mistakes 45 (below 15 satisfactory); symptoms 12; overall pass mark 25.
• Mistakes: high gearing, overtrading, big project (15 each). Symptoms: financial signs 4, creative accounting 4, non-financial signs 3, terminal signs 1.
• Strengths: causes, early warning, covers management. Limits: subjective, hidden information, arbitrary marks, snapshot.
• Quantitative models: objective but backward-looking. Use both.

How the marks are earned

• Describe the model: three groups, what each contains and the thresholds.
• Score: correct marks, group totals and overall total.
• Discuss: two strengths and two limits, and a view on using both approaches.

Practice questions

These are original questions, written in the style of the Skills examination. Work each one before you open the answer.

Recall check: multiple choice

Section B style: written questions

Model answers

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