Predicting bankruptcy: will your business exist next year?

Last week we discussed how you can take some numbers from your latest financial statements and calculate the maximum sustainable rate at which you can grow – the Sustainable Growth Rate. We showed how firms that grow too fast may run out of cash and die. This week we’ll look at how you can reliably predict the bankruptcy of the your business (or a suppliers business) two years in advance – giving you time to mitigate disaster and minimise your losses. For anyone extending credit, considering buying a business (or investing in one), or anyone involved in setting the goals for a company this is crucially important.

Introducing the Altman Z-score:

In 1968, Edward Altman (Assistant Professor of Finance at New York University) published his formula. What Altman did was to compare a database of firms that had defaulted with another set of similar sizes and industries that hadn’t. He then applied the statistical method of discriminant analysis to arrive at a linear combination of 5 common business ratios weighted by coefficients.

What’s important is that this 1968 formula has been statistically tested with sets of data from then until 1999 and has been found to be reliably 80-90% accurate at predicting bankruptcy 1 year before the event. As with any statistical test there is always a risk of a ‘false positive’ (i.e. predicting bankruptcy which doesn’t then happen) – the risk of this is estimated at 15-20%. Since the analysis of published financials provides little insight into what changes management took at those companies who survived their bankruptcy prediction, my personal hypothesis is that what the false positives really show is that 15-20% of firms heading towards bankruptcy can fight their way out of it given advance warning, which is a more hopeful message. Note that I can’t back this up with any data either!

It’s also important to note that the Z-score differs for manufacturing and non-manufacturing firms, as well as those privately held. It’s unsuitable for financial services since they have often structure both assets and liabilities into special purpose vehicles or other off-balance sheet items.

The formula:

You’ll need your latest Income Statement and Balance sheet: here is the Z’-Score (the modified version for private firms). You’ll see that it has five parts, each of which is a specific coefficient multiplied to a standard financial ratio. It’s nothing to be scared of:

Z’ = 0.717T1 + 0.847T2 + 3.107T3 + 0.420T4 + 0.998T5

T1 = (Current Assets − Current Liabilities) / Total Assets. This measures liquid assets in relation to the size of the company.

T2 = Retained Earnings / Total Assets. This measures profitability that reflects the company’s age and earning power.

T3 = Earnings Before Interest and Taxes / Total Assets. This measures operating efficiency apart from tax and leveraging factors. It recognizes operating earnings as being important to long-term viability.

T4 = Book Value of Equity / Total Liabilities. Adds market dimension that can show up share price fluctuation as a possible red flag.

T5 = Sales/ Total Assets. This is a standard measure for total asset turnover but varies greatly from industry to industry.

What the results mean:

Z’ > 2.9 -“Safe” Zone: you are highly unlikely to go under any time soon.

1.23 < Z’ < 2. 9 -“Grey” Zone: the closer you are to the a score of 1.23 the more likely you are to be in serious financial difficulty.

Z’ < 1.23 -“Distress” Zone: 80%-90% of firms in this zone will go bankrupt within a year. ±15% of the firms in this zone won’t. Odds are against you.

Practical application:

In the Altman Z-score we have an accurate and useful formula that can help us predict the failure of the firm. If that’s our business then we can hopefully get into some meaningful discussion around the future of the firm and how to fix it – action ASAP is requried. If that’s a customer then we need to be very careful around credit terms and how much business we do with them. If it’s a supplier then we should start to look around for different suppliers (and possibly ask for more credit, since there’s a chance we’ll never have to pay it back). For someone investing in or buying a business where the Z-score is dodgy I’d urge you to consider whether the problems in the business can be fixed before it sucks your capital away forever…or if you must buy the business then structure the deal so that anything above liquidation value is only paid if the business is still alive 2 years hence.

I’d be interested in hearing from anyone who has traded their way out of a Z-score of 1.23 or lower and what you did to fix things.

How fast can your business sustainably grow?

Growth rates mark the ambition and drive the valuation of any business. They are very important yet hard to get right. Very few companies achieve growth of both sales and profits; many will achieve a growth in sales but profitability will remain flat or decline somewhat; and even more will contract or even close completely. One of the sad facts of entrepreneurship is that many SMBs that fail do so in their year of best sales. The reason: they have grown too quickly and have over-traded, leading to too much cash being locked-up in the working capital cycle and too little liquidity remaining. Something happens and the business takes a knock but doesn’t have the cash to roll with the punch and is liquidated. In even sadder cases the owner sets a growth target higher than is financially sustainable and the very sales people that achieve the target are unemployed within months.

Furthermore, when raising money or trying to sell the business all entrepreneurs will tell you how they expect their business to grow easily and rapidly, yet the astute lender/investor/buyer will need to interrogate how much growth is actually possible.

So how do we predict how fast a business will grow and can grow?

The reality is that predicting growth is very hard. Prior performance will give insight into what’s been achieved to date, however if you looked a prior performance v. prior forecasts its almost certain you’d see under-achievement by the business relative to earlier expectations (you’d be lucky to find this information of course: it’s not something management are normally proud of).

We can follow a top-down process to predicting the growth rate of a firm: start with the country’s growth rate. Then compare the expected growth rate for the industry. Is there any reason why the industry itself will grow faster or slower than the country? Then speak to your suppliers to understand how fast they expect to grow. Why? What about your customers: how fast do they expect to grow and will you receive your expected ‘share’ of that growth? If one keeps objective through this process (and if you repeat it quarterly) you’ll quickly get to a range of believable numbers and a clear thesis as to why they’re believable. You’ll have a range of growth forecasts with a lower (pessimistic) and higher (optimistic range).

As a first check, comparing these to the country’s inflation rate tells you immediately if real value is being created or destroyed, but can the firm actually achieve this growth?

The ‘Sustainable Growth Rate (“SGR”) is a very useful concept developed by Robert Higgens. It describes optimal growth from a financial perspective assuming a given strategy with clear defined financial frame conditions/ limitations. Sustainable growth is defined as the annual percentage of increase in sales that is consistent with a defined financial policy (target debt to equity ratio, target dividend payout ratio, target profit margin, target ratio of total assets to net sales). In other words, the SGR for any firm depends on your capital structure, dividend payout ratio, profit margins, and asset utilisation – changing any of these has an impact on the amount of growth your firm can achieve. Here is the formula:

SGR = (pm*(1-d)*(1+L)) / (T-(pm*(1-d)*(1+L)))

  • pm is the existing and target profit margin
  • d is the target dividend payout ratio
  • L is the target total debt to equity ratio
  • T is the ratio of total assets to sales

Putting this into practice: get your partners/senior management to come up with optimistic and pessimistic growth forecasts for your firm, preferably for each product line/market/region and customer. Look closely at the ones where opinions vary widely and try to understand what drives those differences. Arrive at your growth target for the next financial year. Compare this to inflation (about 5.6% in South Africa). Then take your most recent financial statements and calculate the SGR using the formula above.

If your growth targets/expectations are above your SGR, then you’ll need to invest more equity capital, reduce dividend payouts, increase financial leverage or increase your target profit margin. If you don’t do this you may still achieve your desired growth, but it will be unsustainable and depending on the strength of your balance sheet there is a good chance you’ll be desperately hunting for cash (and survival) within a few months.

Conversely, if you expected growth is well below the SGR, then there is potential to reduce leverage or increase dividends (your preference) without risking the potential of the business. Some simple playing around with your inputs to your SGR calculation will greatly help you understand how much growth is realistic for your firm.

This is crucial information for management, for sales teams, for investors/funders and for the buyers of any business…don’t set (or accept) targets without it.

When to pay a dividend?

Today we’ll look at how firms return excess cash to their shareholders, which normally happens through dividend payments or share re-purchases.

A business can be highly profitable and well run, and cash reserves can (hopefully) accumulate quickly. Hopefully the firm is looking out for growth and investment opportunities and can find investments that offer risk-adjusted returns higher than its cost of capital – in which case it should make those investments as they add value to the firm. However, firms don’t always have these opportunities and so the question becomes what to do with the excess cash they are building up? The core principle of finance is that if a firm doesn’t have attractive investment opportunities, it should return excess cash to shareholders who can then choose to invest elsewhere. Breaking this down into its parts helps us understand the issues

How much cash is ‘excessive’?

A business needs cash to finance its working capital cycle and to fund growth (the amount of funding that growth requires depends on the working capital cycle); it also needs to keep cash reserves that will enable it to withstand a severe knock – in most cases this is enough cash to cover 6 months operations with no income. Above this, the firm probably has excess cash and if it can’t find suitable projects to invest in then it should return the cash to shareholders.

How do we return it shareholders?

Cash can be returned to shareholders in the form of dividends or share repurchases. Dividends are the more common way to return cash, however they may carry secondary taxes that are paid by the company (this was the case in South Africa, but dividends are not taxable in the hands of the recipient). Dividends are treated as tax-free income in the hands of their recipients (having already been taxed as income to the firm and again with the secondary tax). A share repurchase is simply the opposite of issuing new shares in exchange for capital: in the repurchase the firm pays money to shareholders in exchange for their shares, which gives the shareholders a lump sum of cash and reduces the overall equity value of the firm. Keep in mind that reducing the equity in the firm by either dividends or share repurchases changes the capital structure of the firm in that it is more heavily geared subsequently.

What factors apply differently to small businesses than large companies?

In big companies, dividend policy is taken very seriously as it determines they type of investor who buys the shares in the firm. For example, investors who are either retired or nearing retirement tend to favour the steady cash flow of a predictable dividend than the potential of capital growth. This means that the pension funds in which they’ve invested in turn invest in shares that meet the preferred criteria of the investors in the fund. Other investors/funds (with typically younger investors) look for higher growth and don’t care much for dividends.

Generally, firms like to pay predictable dividends that grow each year while retaining sufficient cash for their growth. A large corporate who has large cash reserves might find themselves an attractive acquisition target, and would reduce their attractiveness by declaring a large dividend. As you can imagine, there are books on the subject, Doctorates to be earned and friendships to be lost in setting dividend policy.

In small companies, dividends are a much more fickle thing although they shouldn’t be. What I see too often is the owner who needs to refurbish his house or pool and draws cash from the business in order to do so, leading to the business growing more slowly or even struggling. I always stress how important it is to draw a firm line between business and personal finance, yet most entrepreneurs more or less have to blur this line in times of high business or personal financial needs. My advice regarding dividends is first to set a clear policy around determining how much cash should be held in the business (for example, 6 month’s working capital at any stage – or more for seasonal businesses). Make this dividend policy absolute and put it in the shareholders agreement. Then you have clarity and a policy – in good years you can look forward to a dividend and in bad years you’ll be protected from yourself by a firm policy amongst shareholders.

Remember to ask for help if anything here has confused you: @valuationup

Which investments should a firm make?

To recap, Corporate finance as a discipline tries to maximise the value of the firm by (a) investing in assets that earn a return above its hurdle rate, (b) optimising the mix of debt and equity to fund the firm, and (c) returning money to shareholders in the form of dividends or share buy-backs if the firm can’t succeed at (a). These principles are universally applicable to all firms, of any size or location.

In the last quarter of 2011, we covered the core principles of what drives valuation and the cost of capital, effectively giving you the tools to determine the optimal mix of debt and equity to fund the firm and to quantify its Cost of Capital. In the framework above, this gives you the tools to tackle (b). In the next few articles we’ll turn our attention to answering the other core questions in corporate finance (a) what projects should be invest in that increase the value of the firm? and (b) when should we declare dividends or buy back shares? Both of these are common areas of misconception and value-destruction in the world of smaller businesses.

Lets start with the decision around which projects a firm should invest in if it is to increase its value:

The high-level answer is simple: firms should invest in projects that offer risk-adjusted returns higher than the minimum acceptable hurdle rate.

Unpacking this, there are two things we need to understand: 1. What are the risk adjusted returns, and 2. What is the minimum acceptable hurdle rate?

Understanding Risk-adjusted returns requires understanding the magnitude and timing of cash-flows from the investment project as well as all side effects. In most projects we expect cash outflows before inflows. Over the life of the project we hope to be in a situation where the total inflows are higher than the outflows plus their financing cost. The key thing to realise is that any project/investment takes up time and money, both of which are scarce. As such, taking one project now can prevent us from taking on a better one later (opportunity cost). So aside from a good fundamental understanding of the projects inflows and outflows, you also need to make a judgement call around what future opportunities you’ll be excluding. We’ll go into some detail around how to do this in the next weeks.

Determining the best hurdle rate to use depends on the size of the firm and the project. In the world of large investments (typically those made by large corporations), the individual project will have its own mix of debt and equity funding and its own risk profile. In which case the hurdle rate will be set based on the risk profile and financing mix of the specific project. For most entrepreneurs the typical situation is that all funding to the business gets spread across all investments without any change in the mix of funding used, so stick simply with your Weighted Average Cost of Capital calculation (see previous articles); for those with specific assets (such as vehicles, property, or machinery & equipment) where different types of commercial loans are available it makes sense to take them – there is no point using your bond to finance a car: you’ll be paying for the car 20 years after you last used it.

Why do we use the firms’ cost of capital as the hurdle rate? If the firm invests in a project where the returns are lower than the cost of capital, then the earnings of the firm will be diluted by the relatively poor investment and the return to equity holders will drop (as more of the return on equity is used to pay debt-holders first). Conversely, if a firm invests in projects that offer returns higher than the cost of capital, then returns to equity holders are being increased.

In the next weeks we’ll unpack the investment decision further, before moving on to understanding when to return cash to shareholders via dividends or share re-purchases.

Remember to ask for help if anything here has confused you: @valuationup