Interconnection between Achieved Level of Return on Equity and Evaluation Scale of the Kralicek´s Model

Abstract

A large number of diagnostic and predictive models exists using different or no statistical methodology. Often, diagnostic and predictive models differ in focus on branch of company, size of company, tradability of shares, country of usage, focus on maturity of the market environment. Many of the models are widely used, however, their explanatory power is not known. Good examples of these models are those used in banks in the process of creditworthiness assessment. Some of them are created based on the Q-Test model. However, not only banks need to check the financial situation of companies. Basic users are also suppliers, customers and other business partners. This article deals with Kralicek´s Q-Test which is one of the well-known financial diagnostic models in Europe including the Czech Republic. Its five grade rating scale reveals little about the level of prosperity of analysed companies. An assumption exists that grade 1 means excellent financial health. However what exactly does it mean? Can it be assumed that this means a negligible to zero probability of bankruptcy and simultaneously a sufficient or a high profitability? The question is what is the level of prosperity connected with the grades achieved on the Q-Test evaluation scale from 1 to 5. The prosperity of the company is uniquely linked to the return on equity. Another question is whether the Q-Test is able to express a level of prosperity and not only a level of creditworthiness of companies. That is why the research based on analysis of dataset of 1504 Czech companies was carried out. Following the research a scale was made of achieved return on equity (ROE). ROE levels are expressed by the following: implicit cost of equity (re), risk-free rate (rf), positive ROE, negative ROE and negative equity (or insolvency). The researched found that the Q-Test´s informative value is comparable to the predictive models based on statistic techniques.