Technical
Reference
Bulletin
No. 104
Check performance regularly
If you really want to avoid bankruptcy,
try calculating the Z score.
he original Z score was created by Edward Altman in the mid 1960’s. It is the most
widely used of the many bankruptcy classifications that exist, and it has stood the
test of time. To arrive at his formula, Altman looked at the financials of 66 publicly
traded manufacturers: 33 had filed for bankruptcy; 33 had not. Out of a selection of
22 financial ratios, he found 5 that could be combined to discriminate between the bankrupt
and the non bankrupt companies in his study. Later, Altman created what he calls the four
variable version (see Figure 1). Also widely used, this version is appropriate for both public
and private firms, and for both manufacturers and service companies.
T
To get the Z score, you simply take the figures for the four ratios, which Altman calls
X1, X2, etc., from your financial statements. Multiply their values by coefficients Altman
has derived, and add up the results. The formula, explained in detail below, looks like this:
6.56 (X1) + 3.26 (X2) + 6.72 (X3) + 1.05 (X4)
Total score greater than 2.60, things are looking good.
If it is less than 1.10
, bankruptcy may well be in sight.
Though developed to
measure the likelihood of
bankruptcy, can be used as
a handy measure of overall
financial performance.
The interesting thing about the Z score is that it is a good analytic tool no matter what
shape your company is in. Even if your company is very healthy, for example, if your Z
score begins to fall sharply, warning bells should ring. Or, if your company is barely
surviving, you can use the Z score to help evaluate the projected effects of your turnaround
efforts. To find your company’s Z score, first calculate the four ratios.
X1 =
Working Capital
Total Assets
This measure of liquidity compares net liquid assets to total assets. The net liquid assets,
or working capital, are defined as current total assets minus current total liabilities.
Generally, when a company experiences financial difficulties, working capital will fall more
quickly than total assets, causing this ratio to fall.
X2 =
Retained Earnings
Total Assets
This ratio is a measure of the cumulative profitability of your company. To some degree,
the ratio also reflects the age of your company, because the younger it is, the less time it
has had to build up cumulative profits. This bias in favor of older firms is not surprising,
given the high failure rate of young companies.
When a company begins to lose money, of course, the value of total retained earnings
begins to fall. For many companies, this value —and the X2 ratio—will become negative.
EBIT
X3 = Total Assets
This is a measure of profitability, or return on assets, calculated by dividing your firm’s
EBIT (earning before interest and taxes) for one year by its total assets balance at the end of
the year.
Profits are good, assets are bad, liabilities are worse
You can use EBIT divided by Total Assets as
a measure of how productively you are using
borrowed funds. If the ratio exceeds the
average interest rate you’re paying on loans,
you are making more money on the assets
purchased (ie. your loans) than you are paying
in interest.
included.) Compare your own calculations with
industry ratios, and find the ones that are out
of line.
When you make this comparison, however,
I’ve found it’s very natural to excuse low ratios
by saying, “We’re different.” Suppose, for
example, that your X3 ratio is lower than your
Net Worth
industry average. You might say, “We’ve made
X4 = Total Liabilities
a much greater investment in production
This ratio is the inverse of the more familiar equipment than our competitors, giving us an
advantage.” But if this additional investment
debt-to equity ratio. It is found by dividing
your firm’s net worth (also known as stockhold- provides a truly competitive advantage, the
ers’ equity) by its total liabilities. Non bankrupt other ratios should more than compensate for
the low X3 ratio. If not, your competitors may
firms maintain more than twice as much equity
actually have the advantage because they are able
as debt.
to achieve similar profits with a smaller investment in assets and correspondingly smaller debt.
After you’ve calculated these four ratios,
The Z score, you will soon learn, takes a very
simply multiply the X1 ratio by its coefficient,
shown in the formula, the X2 by it’s coefficient, stern view of your financial statements. To the Z
and so on, add the results, and then compare score, profits are good, assets are bad,
liabilities are worse, and current liabilities are
the total with Altman’s cutoff values, "safe"
worst of all. If yours is lower than you would
greater than 2.60; "bankrupt" less than 1.10.
like, you can improve it considerably by selling
The Z score takes a
The purpose of calculating your own Z score marginal assets and using the cash to reduce
very stern view of
is to warn you of financial problems that may
current liabilities. This will improve ratio X1 by
your financial
need serious attention and to provide a guide
both increasing working capital and decreasing statements.
for action. If your Z score is lower than you
assets: it will improve ratios X2 and X3 by
would like, then, you should examine your
reducing assets: and it will improve ratio X4 by
financial statements to determine the reason
reducing liabilities.
why.
In real life, of course, this action can also
Start by calculating the scores from previous make perfect sense. Reducing current liabilities
periods, comparing them with your current
often lowers interest costs and reduced the
score. (Graph them if possible.) If the trend is
possibility that an unhappy creditor will force
down, try to understand what had changed to
you into bankruptcy. Reducing assets can often
create ratios that are dragging your score down. lower overhead costs and improves your return
Monitoring the trend in your Z score can also
on the assets invested in your company.
help you evaluate your turnaround efforts.
Another way to analyze your score is to
compare your results with those of other
companies. Compare these ratios with your
own. You could also refer to the Robert
Morris Associates (RMA) Annual Statement
About the author:
Studies. These studies, to which your banker
Charles W. Kyd spent 10 years as CFO for
probably subscribes, provide detailed financial high-tech and turnaround manufacturers
ratios by Standard Industrial Classification code. and is now a consultant with a Seattle
(Ratio X2 cannot be calculated from RMA data, accounting firm.
however, because retained earnings aren’t
Exchange is a publication of:
Private Equity Services
3003 Northup Way Ste.101
Bellevue, WA 98004
206-999-6000