By Mark T. Jude
In the world of finance there are many different types of risk and even more ways that attempt to measure or estimate that risk. There are a numerous models and methods to estimate the risk of a company’s equity or debt, which are important in determining value. But what about estimating a company’s risk of bankruptcy?
When Shenehon Company values a business, it calculates the business’s Altman Z-Score, which looks at a company’s risk of bankruptcy. The Altman Z-Score model measures a company’s probability of bankruptcy within two years using financial ratios. Instead of looking at financial ratios independently, this model uses multiple ratios to get a complete view of the company as a whole. Ratios in the model look at liquidity, profitability, leverage and operational activity. Each ratio on its own reveals important information and may highlight points of risk for the company, but the Z-Score measures the overall risk of the company.
This model was created in 1968 by Edward Altman, who is still a Professor of Finance in the Stern School of Business at New York University. The original model was created for public companies and Altman later created two additional Z-Score models: one for private manufacturing companies and another for private non-manufacturing companies. For private business valuation we look at the latter two models.
Z-Score Model for Private Manufacturing Companies
The model for private manufacturing companies consists of five weighted factors:
- Working Capital to Total Assets Ratio
- Retained Earnings to Total Assets Ratio
- EBIT (earnings before interest and tax) to Total Assets Ratio
- Book Value of Equity to Book Value of Total Liabilities Ratio
- Sales to Total Assets Ratio
Factor 1 measures the liquidity (current assets minus current liabilities) of the company compared to its assets, in this case net current assets as a percentage of the total asset base. Factor 2 measures the financial leverage of the company, with the difference between the two metrics implying debt or other liabilities. Factor 3 measures the profitability of the company relative to its assets. Factor 4 is another measure of the company’s financial leverage, looking at total capital. Factor 5 measures the company’s ability to generate sales with its current level of assets. After the ratios are calculated they are entered into the Z-Score formula shown below:
Z-Score = 0.717(F1)+0.847(F2)+3.107(F3)+0.42(F4)+0.998(F5)
To interpret the Z-Score one must compare it to three scoring ranges. A score above 2.9 indicates that bankruptcy is not likely. A score between 2.9 and 1.23 is known as the “grey” zone where bankruptcy may occur but is not imminent. A score below 1.23 indicates the company is distressed and is likely to file for bankruptcy within two years.
Z-Score Model for Private Non-Manufacturing Companies
The model for private non-manufacturing companies is altered slightly. This model omits Factor 5 and has different weighting and scoring ranges. The model for private non-manufacturing companies is shown below:
Z-Score = 6.56(F1)+3.26(F2)+6.72(F3)+1.05(F4)
For this model a score above 2.6 indicates that bankruptcy is unlikely and a score under 1.1 indicates that bankruptcy is likely, while a score between 2.6 and 1.1 is the “grey” zone and is not a clear indicator. According to Predicting Financial Distress of Companies: Revisiting the Z-Score and ZETA Models by Professor Altman, multiple tests performed from 1968 to 1999 have demonstrated that “the accuracy of the Z-Score model on samples of distressed firms has been in the vicinity of 80-90%, based on data from one financial reporting period prior to bankruptcy.” The model predicted that a company would be bankrupt within the next two years and was incorrect on 15% to 20% of the time in these studies.
This model can point to weak areas in a company’s financials and show where efforts of improvement would make the largest impact, thereby minimizing the probability of bankruptcy. For manufacturing companies or asset-intensive companies, it is common that the sales to total asset ratio has the largest impact on the Z-Score. The model for non-manufacturing companies does not have a clear key factor and will vary on a case by case basis.
An advantage of the Z-Score Model is that all of the inputs are readily available on financial statements, making it simple to gather the required inputs. There is no regression, calibration or complex statistical model needed to implement this model. There are no assumptions made and the model does not rely on market data. Another benefit is that the model is easy to interpret. The score falls into one of the three categories, likely of bankruptcy, not likely of bankruptcy or in the “grey” zone of no indication. Overall, this model is a good way for an investor, credit analyst, auditor, appraiser or business owner to estimate the company’s risk of bankruptcy.