Predicting Financial Distress - The Z-Score Analysis

::: By :::
Asma Rafique Chughtai
asmarafique@vu.edu.pk

“You’re neither right nor wrong because other people agree with you.
You’re right because your facts are right and your reasoning is right –
that’s the only thing that makes you right. And if your facts and reasoning
are right, you don’t have to worry about anybody else.”
Warren Buffett- American legendary investor

Every rational investor who intends to invest in a company desires to have maximum return
from that investment. It requires making investment decision after analyzing the projected
company from different perspectives. However, a special emphasis is on determining that
company’s profitability and repaying capacity. The rationale behind it is to ensure that the
company is able to pay the money it owes to the investors/shareholders and creditors or is in
financial distress?
Financial distress is defined as a state under which a company faces difficulty or is unable to pay
the money it dues to the creditors and shareholders. These companies are characterized by
illiquid assets, high leveraged costs and returns highly sensitive towards economic
circumstances. This condition leads the company towards bankruptcy unless proper remedial
measures are adopted to put it back to the track of financial stability.
Investors can protect themselves from losses that may incur as an aftermath of investment in a
company that is on the verge of bankruptcy provided they are aware about the bankruptcy
position of that company prior to investment. To identify companies’ repaying capacity,
investors calculate and analyze various ratios. Although ratio analysis serves as an effective tool
for determining the financial strengths and weaknesses of a company’s performance but the fact
is that every ratio is distinctive in nature and guides the investors from a different perspective.
Moreover, sometimes many of these ratios oppose each other. Consequently, it is difficult for the
investors to come up with an accurate opinion about whether the company is away from
bankruptcy or is moving towards bankruptcy.
To detect the possibility of a company’s bankruptcy in advance, Edward I. Atlman developed Z
Score Analysis in 1960’s.
Edward I. Altman is serving as a Professor of Finance at Stern School of Business, New York
University. His name is listed among 100 most influential people in financial research by the
Treasury & Risk Management Magazine of UK. He is known worldwide for his research in the
areas of credit risk analysis, corporate bankruptcy, capital markets and regulations in banking.
Z score analysis is a diagnostic measure of corporate financial health developed by Altman to
forecast the probability of bankruptcy in a company within a period of 2 years. It was developed
after an in depth research conducted on 66 manufacturing companies. These 66 corporations
were divided in to two equal groups i.e. 33 bankrupt companies with assets size between $1
million to $26 million and 33 non bankrupt healthy firms with assets size between $5 million to
$130 million. 22 common ratios were calculated and analyzed on all these selected companies.
Financial data of these companies were taken from Moody’s industrials manuals and from the
respective companies annual reports. Multiple Discriminant Analysis was applied in this research
which is a statistical analytical tool through which many characteristics can be summarized in to
a single score.
Outcome of this study revealed 5 ratios that were sorted out of 22 ratios analyzed. These 5 ratios
perform best collectively in predicting the probability of bankruptcy. Ratios are weighted with
Discriminant Coefficients and then summed up. Final score is known as “Z Score”. The Z score
formula is as follows:
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
1.2, 1.4, 3.3, 0.6, and 1 represents Discriminant weights or coefficients assigned to the ratios and
X1 to X5 are the five ratios screened.
X1 represents Working Capital/Total Assets (WC/TA). This ratio determines the liquidity
position of a company in comparison to the total capitalization. Working capital is the difference
between current assets and current liabilities. Companies that hold positive working capital in
relation to total assets are generally strong enough to pay the liabilities due. In contrast
companies with negative working capital could be on the road to bankruptcy.
X2 represents Retained Earnings/Total Assets (RE/TA). This ratio determines the leverage
position of the company. Retained earnings refers to the amount of money which is not
distributed to the shareholders out of net profit and is retained by the company either for further
investment or for meeting the contingencies. These are added in shareholders’ equity of the
companies. Generally companies who possess high retained earnings as compared to the total
assets finance their assets through the reinvestment of profit in to the business instead of taking
debt. Consequently, it depicts company’s strength in relaying on internal equity rather than
external equity.
X3 represents Earnings before Interest and Taxes/Total Assets (EBIT/TA). This ratio
determines the ability of the company’s assets in generating profits independent of taxes and
finance costs. It illustrates the earning power of assets. A high ratio indicates potential of
company’s assets in generating operating profits.
X4 represents Market Value of Equity/Book Value of Total Liabilities (MVE/TL). This ratio
determines the proportion by which a company’s assets are financed through equity and debts
(assets value determined by market value of equity and liabilities). It gives market dimension to
the analysis as it shows the actual worth of company’s equity in the market i.e. it adds technical
analysis perspective which is not based on fundamentals. Companies whom liabilities exceed
market value of equity fall close to bankruptcy.
X5 represents Sales/Total Assets (S/TA). This ratio determines the efficiency of the company’s
assets in generating sales. It is also known as Total Assets Turnover.
Interpreting a company’s Z score is quite easy.
Z > 2.99 “Safe” zone
 A score above 2.99 indicates that company is in
1.81 < Z < 2.99 “Grey” zone
Safe zone and is not leading towards bankruptcy. Z < 1.81 “Distress” zone
 A score between 1.81 and 2.99 indicates that
company is in Grey zone meaning by it is neither safe nor is about to be declared as
bankrupt. In this situation, a detailed analysis should be conducted to locate the area that
is creating gap between Safe zone and Grey zone and for taking further remedial steps by
the company’s management.
 A score below 1.81 indicates that the company is in Distress zone and is leading towards
bankruptcy.
Primarily this model was formulated for manufacturing companies therefore it was criticized by
many financial experts and researchers due to non applicability on certain sectors as two of the
above mentioned five ratios are not applicable to all business sectors.
First one is X4-Market Value of Equity/Book Value of Total Liabilities (MVE/TL). This ratio
can be calculated only for public companies therefore investors cannot calculate it for private
companies. Second one is X5- Sales/Total Assets (S/TA). It differs with respect to industry such
as for non manufacturing and emerging markets credits. For example, there is no concept of sales
in case of banks as banks are service providing companies and do not have sales so it cannot be
calculated for banks.
To resolve the conundrum, Altman developed multiple versions of Z score analysis after
thorough research on these respective sectors i.e. Z score for Private Companies and Z score for
Non Manufacturing and Emerging Market Credits.
For private companies, X4-Market Value of Equity/Book Value of Total Liabilities (MVE/TL) is
replaced with Book Value of Equity/Book Value of Total Liabilities (BVE/TL). Book value of
equity is the net worth of the company and can be calculated by subtracting total liabilities from
total assets. Thus the issue of calculating market value of equity for private companies is no
more in existence.
Z score formula and its interpretation for private companies is as follows:

Z = 0.717X1 + 0.847X2 + 3.107X3 +0.42X4 + 0.998X5

Z > 2.9 “Safe” Zone

1.23 < Z < 2. 9 “Grey” Zone
Z < 1.23 “Distress” Zone
For non manufacturing and emerging companies, X5 i.e. Sales/Total Assets is not required to be
calculated. Z score formula and its interpretation for Non-Manufacturer Industrials & Emerging
Market Credits is as follows:

Z = 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4

Z > 2.6 -“Safe” Zone

1.1 < Z < 2. 6 “Grey” Zone
Z < 1.1 “Distress” Zone

Generally, Z score analysis gives 72-80 % correct results within a period of 2 years and is quite
authentic. However, like other analytical tools it is also subject to certain limitations.
It provides accurate results to the extent up to which the information given in financial
statements depicts. Generally, companies use to understate their profits to take the advantage of
tax evasion. Therefore Z score result would be misleading for those companies whom statements
are window dressed. Moreover, Z scores are affected when exceptional write offs are recorded
by companies time to time thereby resulting high variation in scores.
In spite of the above mentioned limitations, the effectiveness of Z score cannot be denied. That is
why it is used worldwide by many financial experts, consultancy firms, investors, companies’
management, etc as a valuable analytical tool for determining the chances of bankruptcy in
companies.
Summing up, Z score analysis should be conducted regularly to remain updated about
companies’ performance. Moreover, when the scores show significant variations for consecutive
years; other detailed analyses should be conducted. Most importantly, relying only on this
analysis is not wise. It should be used as a tool that complements other analytical tools.
References:
Altman, E. I. (2000, July). PREDICTING FINANCIAL DISTRESS OF COMPANIES:
REVISITING THE Z-SCORE AND ZETA MODEL. Retrieved from International
Insolvency Institute:
http://www.iiiglobal.org/component/jdownloads/viewdownload/648/5645.html

McClure, B. (2011, January 15). How To Calculate A Z-Score. Retrieved from Investopedia:
http://www.investopedia.com/articles/fundamental/04/021104.asp#ixzz1V6njlQJs

Mohan, M. (2012, October 21). 79 Warren Buffett Quotes On Investing. Retrieved from
Minterest: http://www.minterest.com/warren-buffet-quotes-quotations-on-investing/
Error: Reference source not found Edward Altman PhD. (n.d.). Retrieved from Financial Sense:
http://www.financialsense.com/contributors/edward-altman-phd