Bankruptcy occurs when a company is unable to meet maturing financial obligations and petitions a Federal court either for liquidation (Chapter 7) of its assets or reorganization (Chapter 11) of its debts. A company generally receives debt relief in Federal court if it is unable to liquidate its debts as they come due by transferring its assets to a trustee or by agreeing to reorganize its liabilities. It is possible that a company filing for bankruptcy did not adequately evaluate its bankruptcy risk. How then can a company sufficiently evaluate its bankruptcy risk? More specifically, how can a company use financial ratios to best evaluate its potential to fail sufficiently in advance so that corrective action can be taken?
Various financial ratios were studied from a quantitative perspective as bankruptcy predictors, but most of the studies were confined to academics. These researchers attempted for years to identify the best ratio for predicting company bankruptcy. One study concluded that the cash flow to debt ratio was the best bankruptcy predictor; whereas, another study concluded that the net working capital to total assets ratio was the better. The critical shift from a single best ratio as a bankruptcy predictor came in 1968 when Dr. Edward Altman built a comprehensive statistical model using multiple discriminant analysis (MDA).
Dr. Altman’s model, called the Z-Score, represents the probability for bankruptcy and provides the ability to evaluate the general financial condition of a company. His model measures the probability of a company entering bankruptcy within the next two years. Although his original model is for publicly traded manufacturing companies, he developed models for privately held manufacturing and service companies using the same MDA approach. Dr. Altman is known today as the founding father of predicting company bankruptcy using statistics with a high degree of accuracy and his Z-score is the world standard for measuring the overall health of any business.
Dr. Altman developed his original Z-score from an analysis of 33 manufacturing companies that filed for bankruptcy between 1946 and 1965. He started by testing 22 financial ratios that were intuitively possible as bankruptcy predictors. After repeated testing, he excluded the ratio that contributed least to predicting bankruptcy. He eventually came up with a model containing five ratios that, when added together in proportions determined by the MDA procedure, correctly classified 94% of the bankrupt companies one year before they filed for bankruptcy and 72% two years before they filed. The Z-score calculates five ratios:
- Working Capital to Total Assets
- Retained Earnings to Total Assets
- Return on Total Assets
- Sales to Total Asset (Asset Turnover)
- Equity to Debt
How It Works
Dr. Altman’s Z-Score is the sum of adding the results of five ratios each multiplied by a predetermined weight (factor). The formula is Z = 1.2A + 1.4B + 3.3C + 0.6D + E, where:
A is the Working Capital to Total Assets ratio (X1)
B is the Retained Earnings to Total Assets ratio (X2)
C is the Earnings Before Interest and Taxes to Total Assets ratio (X3)
D is the Market Value of Equity to Book Value of Total Debt ratio (X4)
E is the Sales to Total Assets ratio (X5)
The data needed for the Z-Score is easily found in the financial statements:
- Net Sales
- Earnings Before Taxes
- Total Assets
- Working Capital
- Total Liabilities
- Market Value (or Book Value) of Equity
- Retained Earnings
A higher Z-Score means a lower the probability of bankruptcy, so a score of 4.0 is better than a score of 2.0, but it does not necessarily mean it is twice as good since the model is not linear. A score above 3.0 indicates that bankruptcy is unlikely and a score below 1.8 indicates that bankruptcy is probable. Notably, a score below 1.2 indicates a strong (almost certain) probability of bankruptcy. A score between 1.8 and 3.0 (referred as the ‘gray are’ or ‘ignorance zone’ area by Dr. Altman) is inconclusive meaning that if the score falls within this range, the company has a chance of going bankrupt, but it is not certain that it will. Higher scores generally occur when a company has a high level of equity (or a low level of debt).
Why It Works
The Z-Score’s predictive power is best explained by looking at each ratio separately.
Working Capital to Total Assets: This ratio measures the working capital (or the net liquid assets) of a company relative to its total capitalization. Working capital is the difference between current assets and current liabilities. Assets are current if they are converted into cash or used within one operating cycle, which is usually one year but could be longer. Cash, accounts receivable and inventories are examples of current assets. Current liabilities are obligations a company expects to pay within one operating cycle. Accounts payable, short-term debts and taxes payable are the most typical current liabilities. A company with negative working capital generally has difficulty meeting its short-term obligations because there are not enough current assets to cover them. Conversely, a company with positive working capital rarely has problems paying its short-term obligations. A company with consistent operating earnings will have increasing working capital relative to total assets.
Retained Earnings to Total Assets: This ratio measures the retained earnings of a company relative to its total capitalization. Listed on the balance sheet (or statement of financial position), retained earnings are the total amount of a company’s net earnings since it began less dividends paid to stockholders. Retained earnings are a part of stockholders’ equity and represent the company’s assets financed from its profits rather than from selling stock to investors or borrowing from external sources. Significant retained earnings imply a general history of profits; whereas, low or negative retained earnings imply a general history of losses. The incidence of bankruptcy is lower when a company has a history of profits.
Earnings Before Interest and Taxes to Total Assets (Return on Assets): This ratio measures a company’s ability to generate earnings from its assets before any leverage or tax factors (earnings before interest and taxes or EBIT). EBIT, which excludes extraordinary items (unusual and non-recurring items), is often used a proxy for cash flow generated by a company available for distribution between three major groups of claimants: creditors (interest and principal), government (taxes) and shareholders (dividends). A company is technically in default if it does not meet its creditor and government debt obligations.
Market Value of Equity to Book Value of Total Liabilities (Equity to Debt): This ratio measures the stock market’s estimate of a company’s value (or market capitalization) relative to its liabilities. The market value of a company’s equity is the number of its outstanding common stock multiplied by its market price. The value of preferred stock may be included depending on its particular characteristics. Total liabilities are a company’s current and long-term liabilities. A higher ratio means lower leverage.
Sales to Total Assets (Asset Turnover): This ratio measures how efficiently a company generates sales from its total assets. It is determined by dividing net sales by average total assets. A higher ratio means a more efficient company.
The market generally perceives that a publicly traded company with significant market capitalization has a lower risk of bankruptcy because the market believes in its solid financial position and, if it experiences temporary financial difficulties, it could raise money by issuing more common stock. In addition, its creditors will sustain high liquidation costs if they force it into bankruptcy making it an unattractive option. Nevertheless, there has been a trend of larger companies filing for bankruptcy over the past several years. With combined assets of nearly $300 billion, the five largest bankruptcies since 1980 include WorldCom, Inc. (2002), Conseco, Inc. (2001), Enron Corp. (2001), Financial Corporation of America (1988) and Texaco, Inc. (1987).
In the recent bankruptcy of WorldCom, its management improperly recorded billions of dollars as capital expenditures instead of as operating expenses, which overstated its earnings and assets. The Z-Score would have withstood this type of accounting irregularity because the overstated earnings would have slightly increased the X3 ratio (because both earnings and assets increased) and the overstated assets would have decreased the X1, X2, and X5 ratios (because total assets, the denominator, increased). Notably, the combined weight of the X1, X2, and X5 ratios is greater than the weight of the X3 ratio. Therefore, the overall impact on WorldCom’s Z-score is likely to be downward. However, a similar result could have been achieved by a profitable WorldCom making significant capital investments; therefore, care must used when drawing a conclusion using the Z-Score.
From a qualitative perspective, to name a few factors, a company has a higher bankruptcy risk if a company is or has:
- Aging or poorly maintained capital assets
- A cyclical business
- Deficient accounting and financial reporting systems
- Dependent on a few customers
- Dependent on a few suppliers
- High fixed costs
- In a declining industry
- Inadequate insurance coverage
- Lacks quality management
- Less liquid assets
- Less valuable assets
- New or immature
- Privately held
- Significant financing restrictions
- Susceptible to commodity shortages
- Technologically obsolete
- Thinly traded (publicly held)
- Unable to obtain adequate financing
- Volatile or unstable earnings or cash flow
Other than for evaluating a company’s general financial condition and its bankruptcy risk, the Z-Score has other uses:
- Merger analysis
- Loan credit analysis
- Investment analysis
- Auditing analysis
- Legal analysis
The Z-Score is one of several analytical tools used to evaluate a company’s bankruptcy risk. It does not, however, replace experienced and informed personal evaluation because company, industry and economic factors sometime influence the numbers that go into the Z-Score. A trend analysis covering the most recent three to five completed fiscal years must be performed when using the Z-Score. If the trend of a company over a number of years is downward, then that company has problems that could be corrected allowing it to survive – but only if it is caught in time.
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.