ALTMAN Z-SCORE
Where lies its value in
corporate M&A
Presented to ICPAS
“toward a new era in Corporate M&A”
27 March 2004
Dr Raymond Ting, CPA
Nucleus
Capital- Where
Ltd lies its value in corporate M&A
ALTMAN
Z-SCORE
Dr Raymond Ting CPA
1
Nucleus Capital Ltd. All rights reserved.
Agenda
1. Z score basics
2. Accounting ratios
3. Case study
4. Rating for a best fit
5. Forensic
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
2
Nucleus Capital Ltd. All rights reserved.
Z score – a multiple discriminant
analysis technique, developed as
a powerful diagnostic tool
measuring solvency – with ability
to identify bankrupt firms, 12
months in advance, at an
accuracy rate of approximately
95%
Professor Edward Altman,
Stern School of Business,
New York University
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
3
Z = 1.2 x1 + 1.4 x2 + 3.3 x3 + 0.6 x4 + 0.99 x5
Z = overall index of corporate health
x1 = working capital/total assets
x2 = retained earnings/total assets
x3 = earnings before interest and taxes/total assets
x4 = market value equity/book value of total liabilities
x5 = sales/total assets
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
4
Total debt / total assets
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
Nonfailed
firms
Failed firms
5
4
3
2
1
Years before failure
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
5
Working capital / total assets
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
Nonfailed
firms
Failed firms
5
4
3
2
1
Years before failure
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
6
Cash flow / total debt
0.6
0.5
0.4
0.3
0.2
Nonfailed
firms
0.1
Failed firms
0
-0.1
5
4
3
2
1
-0.2
-0.3
Years before failure
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
7
Net income / total assets
0.1
0.05
0
-0.05
5
4
3
2
1
Nonfailed
firms
Failed firms
-0.1
-0.15
-0.2
-0.25
Years before failure
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
8
Current ratio
4
3.5
3
Nonfailed
firms
2.5
2
failed firms
1.5
1
0.5
0
5
4
3
2
1
Years before failure
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
9
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
10
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
11
multiple discriminant analysis
Altman (1968) built a linear discriminant model based only on
financial ratios, matched sample (by year, industry, size)
Z = 1.2 X1 + 1.4 X2 + 3.3 X3 +0.6 X4 + 1.0 X5
X1 = working capital / total assets
X2 = retained earnings / total assets
X3 = earning before interest and taxes / total assets
X4 = market value of equity / book value of total liabilities
X5 = sales / total assets
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
12
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
13
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
14
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
15
Prediction accuracy of the Z score
Year prior to failure
Accuracy rate
1
95%
2
72%
3
48%
4
29%
5
36%
Trade-off Between Robustness and Accuracy
While accuracy may be an academic pursuit,
for cost and practicality purposes, a trend
analysis (by years) of the Z score should
suffice for the purpose of M&A
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
16
1.Caveat emptor - a company appearing
financially fit may in fact be insolvent
or become a bankrupt within a few
short months.
2.Beware of the “living dead” companies
3.Completeness of business model –
are you acquiring just a shelf?
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
17
By convention, an individual with a BMI
of 30 or more is considered obese. This
ratio applies to both men and women.
Ratios do not fluctuate wildly. It is also not
so easy to manipulate ratios. Trend analysis
using z score has predictive value.
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
18
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
19
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
20
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
21
Most M&A due diligence approach consider the use a combination of :1. Financial; and
2. Non financial factors
Financial Factors
Debt service coverage
Leverage
Profitability
Liquidity
Net worth
Share price
Z score
Non-financial Factors
Size and age of company
Industry sector
Age/experience managers
Location
Market position
Judgement
Business synergies/strategies
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
22
1. Important assumption underlying the use of
financial ratios to control for the size differences is
the so-called proportionality between the numerator
and denominator
2. Strict proportionality implicates that there should
exist a linear relationship between the numerator
and denominator of the ratio
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
23
Deviations from strict proportionality assumption
1. Proportionality without constant
Earnings
3. Non-proportionality without constant
Earnings
Sales
2. Proportionality with constant
Sales
4. Non-proportionality with constant
Earnings
Earnings
Sales
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
Sales
24
Actual Outcome
Predicted Outcome
Bankrupt
Nonbankrupt
Bankrupt
Nonbankrupt
Correct
Error: Type II
Cost: Small 0-10%
Error: Type
Cost: Large
Up to 100%
Correct
• Error Rate = false negatives + false positives
• Note that you may care very differently about the two error types
• Cost of Type I usually considerably higher (e.g. 15 to 1)
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
25
ALTMAN Z-SCORE
Ratio analysis
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
26
Nucleus Capital Ltd. All rights reserved.
ACCOUNTING EQUATION
A = L + OE – R + E
Debit
Credit
Credit
Balance sheet
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
Credit
Debit
Profit and loss
27
Adaptation of Lens Model to the study of human judgment
Criterion
(Ecology)
Judgment
Multiple Features
Z
scor
e
Utilization of
Relationship of
features by judge
features to criterion
Brunswick lens model – quality and accuracy of human judgement
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
28
ALTMAN Z-SCORE
Singapore case study
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
29
Nucleus Capital Ltd. All rights reserved.
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
30
Z SCORE
working capital
Total assets
retained earnings and equity reserves on balance sheet
current year earnings before interest and taxes
market value of equity/valuation
total liabilities
total sales
(0.27)
0.97
1.10
1.27
-28.83
133.613
-9.55
-20.534
28
85.967
53.138
7.896
154
11.02
0.933
30
84.659
89.341
22.981
170.174
20.418
0.726
40
90.496
83.239
5.443
143.814
19.566
3.877
56
89.246
82
2001
2000
1999
1998
1. Audited accounts clean
2. No mention of going concern
problems
3. Raised funds via placements and
rights issues cum warrant
1. Company is dying in 1995
2. Insolvent by 1997
3. Company in “living dead” status
by 1998 – continues to look for
strategic investment partners
4. Post mortem status in 2003
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
31
ALTMAN Z score
3.69
3.09
working capital
Total assets
retained earnings and equity reserves on balance sheet
current year earnings before interest and taxes
market value of equity/valuation
total liabilities
total sales
5,995
15,700
5,129
2,303
6,000
9,550
30,086
6,300
29,500
7,983
4,054
10,000
8,204
37,437
15.007
29.539
9.88
6.058
25
11.515
51.852
1998
1999
2000
4.81
4.01
4.72
3.65
16.966 18,010,777
33.836 36,660,291
9.991 10,787,135
0.2489
1,006,229
22 12,000,000
13.503 15,444,268
67.62 116,000,000
16.98
75.06
22.14
4.20
67.00
44.68
141.00
2001
2002
2003
2000 - 2000
2001 - Profit margin affected severe
2002 – marketing strategies successful with new product launching
2003 – major acquisition (goodwill purchased = 50% of NTA)
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
32
Z SCORE
working capital
Total assets
retained earnings on balance sheet
current year earnings before interest and taxes
market value of equity/valuation
total liabilities
total sales
(2.44) (1.07) (0.14) 1.77
-2483061
-1601748
-337159
1.62
2.23
2.61
2.50
2.11
1621111
55322
298381
148710
138420
124557
6681849 10591158
3192782
4388326
7125240
2675555
1726897
1735679
1536740
-2943161
-1933777
-685378
1312126
763533
233162
50344
42481
31867
-925900
-1308399
-1907618
759356
739168
251730
17100
10614
10903
1000000
1000000
1000000
1000000
200000
200000
200000
200000
200000
4935943
5182103
6167227
8079032
6161707
2242393
1476553
1493198
1304882
1963297
3735396
6070789 11705500
7868027
4308174
4065932
3945680
2876429
1999
1998
1995
1994
1993
1992
1991
1997
1996
1993 – private company
1995 – solicit for potential investor
1995 – secured private investor (end 1995)
1996 – duplicated sales scheme boosts sales revenue and profit
1997 – story telling sessions/excuses
1998 – blame it on the Asian crises
1999 – investor remove management
2000 – fraud and creative accounting discovered
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
33
Z SCORE
(2.44)
(1.07)
-2483061
-1601748
3192782
4388326
-2943161
-1933777
-685378
-925900
-1308399
-1907618
1000000
1000000
4935943
1963297
1999
1998
working capital
Total assets
retained earnings on balance sheet
current year earnings before interest and taxes
market value of equity/valuation
total liabilities
total sales
(0.14)
-337159
1.77
1.62
2.23
2.61
2.50
2.11
1621111
55322
298381
148710
138420
124557
6681849 10591158
7125240
2675555
1726897
1735679
1536740
1312126
763533
233162
50344
42481
31867
759356
739168
251730
17100
10614
10903
1000000
1000000
200000
200000
200000
200000
200000
5182103
6167227
8079032
6161707
2242393
1476553
1493198
1304882
3735396
6070789 11705500
7868027
4308174
4065932
3945680
2876429
1995
1994
1993
1992
1991
1997
1996
Investigation ?
•Cost > benefit
•face value
•management time
If in doubt, walk away.
If you know what is going on, devise investment
schemes that will mitigate the concerns/contingencies
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
34
ALTMAN Z-SCORE
Internal rating – looking
for a good fit in an M&A
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
35
Nucleus Capital Ltd. All rights reserved.
CREDIT
GRADES
RISK LEVEL
PD (bp)
S&P
1
Minimal
0-1
AAA
2
Modest
2-4
AA
3
Average
5-10
A
4
Acceptable
11-50
BBB
5
Acceptable with care
51-200
BB
6
Management Attention
201-1000
B
7
Special Mention
1000+
CCC
8
Substandard
Interest Suspense
CCC / CC
9
Doubtful
Provision
CC / C
Default / Loss
D
10
Loss
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
36
Panel A.
Estimation sample of 266 industrial bonds
Actual Rating
AAA
AA
Predicted A
Rating
BBB
BB
B
Total
AAA
10
2
1
0
0
0
13
AA
6
38
7
0
0
0
51
A
1
10
90
10
1
0
112
BBB
1
1
12
28
6
3
51
BB
B
0
0
0
2
5
2
9
0
0
0
0
8
22
30
Total
18
51
110
40
20
27
266
Belkaoui (1983)
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
37
Panel B.
Validation sample of 115 industrial bonds
Actual Rating
AAA
AAA
2
Predicted AA
4
Rating
A
0
BBB
0
BB
0
B
0
Total
6
AA
5
12
0
0
0
0
17
A
0
0
25
0
10
0
35
BBB
0
0
3
21
6
0
30
BB
0
0
0
4
13
3
20
B
0
0
0
0
2
5
7
Total
7
16
28
25
31
8
115
SOURCE: Belkaoui, 1983
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
38
AAA
Extremely low credit
risk
AA+
Very low credit risk
AA
Relatively low credit
risk
A+
Low credit risk
Z>=4
A
Moderate credit risk
Z > = 2.9
B
Above average credit
risk
Z =< 2.9
C
Credit risk is very
high
Z > = 10
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
39
ALTMAN Z-SCORE
Forensic tool for M&A
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
40
Nucleus Capital Ltd. All rights reserved.
Z score spread
16
N um b e r of firm s
14
12
10
Ba n kru pt Zo ne
8
No n ba nkr up t Zon e
6
4
2
< 1.8
Z score
S c ore
10
7
4
1
-2
-5
-8
-1
1
0
>2.9
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
41
Gray areas :•
Creative accounting
16
•
Fraudulent accounting
14
•
Unreliable records
12
•
Misrepresentation
N um b e r of firm s
Normal - Unbounded both sides
10
Ba n kru pt Zo ne
8
No n ba nkr up t Zon e
6
4
2
10
=============== 2.9
7
4
1
-2
-5
-8
-1
1
0
S c ore
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
42
Altman Z score
3.75
w ork ing capital
Total as s e ts
re taine d e arnings and e quity re s e rve s on balance s he e t
curre nt ye ar e arnings be fore inte re s t and taxe s and M I
m ark e t value of e quity/valuation
total liabilitie s
total s ale s
(4.96)
4.37
(41.20)
223.00
(207.00)
125.00
110.00
258.40
707.70
(156.00)
100.00
(328.00)
15.00
110.00
253.00
75.00
(307.00)
225.00
(343.00)
76.00
41.00
527.38
1,571.64
Jan-03
2002
2001
The company results is incomplete. The company is controlled externally.
The strong positive z-score reveals a monopoly position supporting the
company. This support may be temporary and unreliable due to
inconsistency in z-score shows poor financial management and a lack of
consistency.
In order to assess the company more meaningfully, we need a complete
evaluation of the way businesses are conducted.
Valuation of the company is not meaningful at this stage.
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
43
Z score >8, some observation:•
Monopoly – high margins
16
•
Not competitive – too slow
14
•
External “guardian” factor
12
10
Ba n kru pt Zo ne
8
No n ba nkr up t Zon e
6
10
-1
7
2. Ask to see true picture
4
0
1
1. Conduit type arrangement
-2
2
-5
Long term z score below 1:-
-8
4
1
N um b e r of firm s
Normal - Unbounded both sides
========================= > 8
S c ore
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
44
Thank you
ALTMAN Z-SCORE - Where lies its value in corporate M&A
Dr Raymond Ting CPA
45