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.