Predicting Financial Distress (The Z-Score Analysis) by Edward I Predicting Financial Distress (The Z-Score Analysis) by Edward I. Altman 1

Financial Distress A condition where a company cannot meet or has difficulty paying off its financial obligations to its creditors and equity holders.

Edward I. Altman Edward I. Altman is a Professor of Finance at New York University`s Stern School of Business. Dr. Altman has an international reputation as an expert on corporate bankruptcy, high yield bonds, distressed debt and credit risk analysis. He is best known for the development of the Z-Score for predicting bankruptcy published in 1968.

Purpose of Z-Score Analysis Z Score is a general measure of corporate financial health. The purpose of this analysis to find the possibility of bankruptcy in various companies.

Development of Z Score Analysis Sample size: 66 corporations 33 bankrupt (asset size:$1 million to $26 million) 33 with strong financial health (asset size: $5 million to $130 million) 22 common financial ratios were selected and analyzed Financial data were derived from Moody’s Industrial Manuals and also from selected annual reports Multiple Discriminant Analysis was applied (many characteristics can be combined into a single score).

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 Final Product 1.2, 1.4, 3.3, 0.6, and 1 represents Discriminant weights or coefficients assigned to the ratios X1-X5 are the five ratios screened.

X1------ Working Capital/Total Assets(WC/TA) Measure of the net liquid assets of the firm relative to the total capitalization Firms on the road to bankruptcy would be expected to have less liquidity.

X2---Retained Earnings/Total Assets (RE/TA) It measures the leverage of a firm. Those firms with high RE, relative to TA, have financed their assets through retention of profits and have not utilized as much debt. Companies with high RE/TA suggest a history of profitability and the ability to stand up to a bad year of losses. The age of a firm is implicitly considered in this ratio.

X3---Earnings Before Interest and Taxes/Total Assets (EBIT/TA) Measure of the true productivity of the firm’s assets, independent of any tax or leverage factors. A firm’s ultimate existence is based on the earning power of its assets Insolvency occurs when the total liabilities exceed a fair valuation of the firm’s assets with value determined by the earning power of the assets.

X4---- Market Value of Equity/Book Value of Total Liabilities (MVE/TL) The book value of liabilities is the total value of liabilities both long term and current It gives technical analysis perspective to the analysis It determines the proportion by which company’s assets are financed through equity and debts Shows how much the firm’s assets can decline in value (measured by market value of equity plus debt) before the liabilities exceed the assets and the firm becomes insolvent.

X5--------- Sales/Total Assets (S/TA) Illustrates the sales generating ability of the firm’s assets. Also known as assets turnover

Interpretation of Z Score Analysis Results Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 Z > 2.99 “Safe” Zone 1.81 < Z < 2.99 “Grey” Zone Z < 1.81 “Distress” Zone

Validity of Z-Score Analysis To test the model, Altman calculated the Z Scores for new groups of bankrupt and non-bankrupt firms. 95% of the bankrupt firms were correctly classified as bankrupt. Roughly 80% of the sick, non-bankrupt firms were correctly classified as non-bankrupt. Of the misclassified non-bankrupt firms, the scores of nearly three fourths of these fell into the gray area.

In generally, Z Score Analysis gives 72-80% correct results Z-Score Analysis of WorldCom (USA telecommunications giant) in 2002 Mybank Innovation is using Z Score Analysis for its clients

X4??????? What about market value of equity for private companies??? Market Value of Equity/Book Value of Total Liabilities (MVE/TL)

Multiple Z-score Analysis Models Z Score Analysis for Manufacturing Concerns Z Score Analysis for Private Companies Z Score Analysis for Non-Manufacturer Industrials & Emerging Market Credits

Z Score Analysis For Private Companies Z = 0.717X1 + 0.847X2 + 3.107X3 +0.42X4 + 0.998X5 X4----Book Value of Equity / Total Liabilities) Book Value of Equity is net worth Z > 2.9 “Safe” Zone 1.23 < Z < 2. 9 “Grey” Zone Z < 1.23 “Distress” Zone

Z Score Analysis for Non-Manufacturer Industrials & Emerging Market Credits 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

Z Score Analysis Pakistan’s Pharmaceutical Companies KSE Listed

Crux Window dressing in financial statements Z scores application on regular basis A low score indicates that detailed analysis is required Z Score model is a tool that complement your other analytical tools