MBA Accounting & Finance Guide » Interpretation

What Is The Z-Score Model And How Does It Helps To Forecast Business Failures

slang — Sat, 26 Sep 2009 00:00:57 +0000

In interpretating financial statements, whether financial or non-financial managers normally and frequently use the standard traditional business accounting ratio like profitability, liquidity, market based, assets utilization and others.

However, one ratio commonly neglected is the Z-score model which is actually a quantitative model developed in 1968 by an eminent economist, Edward Atlman. So what is this Altman Z-score model and its purpose?

Atlman Z-score model:

Objective:

Is to predict bankruptcy or financial distress of a business using a blend of the traditional financial ratios and a statistical method known as multiple discriminant analysis(MDA)

Applications of this Z-score model in:

Loan and credit analysis to determine whether bankers should extend a loan. For a vendor, he or she can determine whether his customer-company is good for payment after being supplied with the goods/materials/services. For a customer to review whether an important supplier is in financial distress.
Merger analysis-identify potential problem(s) of a merger candidate
Financial management analysis-to help managers to see wheher the need to curtail capital expansion and dividends pay-out

How to Use the Altman Z-Score Model:

(a) First understand its formula:-

Formula:-Z=1.2*X1 +1.4*X2 + 3.3*X3 + 0.6*X4 +0.999*X5

X1=working capital/total assets

X2=retained earnings/total assets

X3=earnings before interest and taxes (EBIT/total assets)

X5=sales/total assets

(b) Next remember its fundamental guidelines:

Z score Probability of failure

1.8 or less Very high

1.81-2.99 Not sure

3.0 or higher Unlikely

_____________________________________________________________

Simple Illustration Using the Altman Z-score model theory to forecast business failure:

Company XYZ has the following financial details:

Total assets=$2,000

Retained earnings=$750

EBIT=$266

Sales=$3,000

Market value of common and preferred stock=$1,425

Book value of debt=$1,100

Proposed solution:

Computation using the Altman Z-score model formula:

Z=X1=400/2000 *1.2=0.240 + X2=750/2000*1.4=0.525 + X3=266/2,000*3.3=0.439+ X4=1,425/1,100*0.6=0.777 + X5=3,000/2000*0.999 =1.499 =3.480

Conclusion:

Since the score is 3.480 Company XYZ falls into the guidelines/classification of “UNLIKELY” zone which means that there is no change that XYZ will go into bankruptcy within the next two years.

_____________________________________________________________

More salient points on Altman Z-score model:

Many found this model is quite accurate re:#90% accurate in forecasting business failure on year into the future and about #80% accurate in forecasting it two years into the future
With the present global credit crunch, it enable the user to predict with reasonable accuracy whether a company is in increasing financial distress so that protective actions like curtailing capital expansion, reducing dividend pay-out or refinancing short term to long term banking structure or facility,etc
Note that this model can be used for a group of companies.

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Snapshot Of Articles Covered Under The Interpretation Of The Financial Statements

slang — Thu, 20 Mar 2008 13:47:43 +0000

Under this heading of Interpretation of financial statements, it is a pre-requisite for any MBA student to have the ability to interpret what’s in the financial statement of a company, hence the need to understand some important financial accounting ratio.

Append below are a list of all articles on interpretation of the financial statement of a company:

PART A:FINANCIAL ACCOUNTING RATIO ANALYSIS OF A COMPANY:

Financial Accounting Ratio Analysis-Commonly or Frequently Asked Questions

Financial Accounting Ratio Analysis- The Common Size Financial Statements As A Tool Used In Ratio Analysis

Financial Accounting Ratio Analysis-Principal Tools Used In The Analysis Of Financial Statements

Financial Accounting Ratio Analysis-Guides To The Analyzing of The Financial Statements

ANNUAL REPORT:

Assessing The Quality Of Management

Assessing The Quality of Earnings

Financial Ratio Analysis-The Market Valued Added (MVA)

Financial Ratio Analysis-The Market To Book Ratio

Financial Ratio Analysis-Sources Of Information Available

Financial Ratio Analysis- The Defensive Interval Ratio

Financial Ratio Analysis-Assessing the LIQUIDITY of a company

Financial Ratio Analysis-Assessing the PROFITABILITY of a company

Financial Ratio Analysis-Assessing The ACTIVITY of assets utilised of a company

Financial Ratio Analysis-Assessing the LEVERAGE OR GEARING of a company

Financial Ratio Analysis-Assessing the MARKET VALUE of a company

Financial Ratio Analysis-ALTMAN Z SYSTEM to forecast BANKRUPTCY of a company.

Price Earning Ratio-Is It A Useful Ratio To Understand?

Financial Accounting Ratio Analysis-Which Ratios have the Value?

USEFUL TIPS ON THE INTERPRETATION OF FINANCIAL STATEMENTS:

How To Spot Companies Which Are Likely To Issue Bonus Issue.

How To Spot Undervaluation in The Notes To The Financial Statements (Part 1 of 2)

How To Spot Undervaluation in The Notes To The Financial Statements (Part 2 of 2)

WHAT IS IN THE ANNUAL REPORT/FINANCIAL STATEMENTS?

Financial Accounting Ratio Analysis-What Is In The Annual Report

Financial Accounting Ratio Analysis-Reading The Chairman Report

The Chairman’s Statement In The Annual Report

Reading The Directors’ Profile In The Annual Report

Notes To The Financial Statement-Related Parties

Notes To The Financial Statement-Income Tax

DUPONT SYSTEM:

Dupont System-An Overview Of ROA & ROE

Dupont System-A Matter Of Leverage Or Is It Financial Efficiency

OTHERS:

What are Growth Companies?

What is Overtrading- Definition, Causes, Consequences And Remedy

Air Asia Bhd –Substance Over Form

What Is Secret Reserve

Financial Accounting Ratio Analysis- Understand What Is Free Cash Flow

Competitive Analysis Using Financial Accounting Ratio Analysis

Financial Accounting Ratio Analysis- What Other Factors Beyong Ratios That Needs To Be Considered

Financial Accounting Ratio Analysis- Basic Understanding of existing and potential net tangible assets basis (NTA)

GEARING-Its Determinants & Advantages and Disadvantages

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Defensive Interval Or Burn Rate Ratio

slang — Fri, 02 Nov 2007 11:17:40 +0000

Normally, defensive internal or burn rate ratio is quite crucial to a start up company like the internet business.Most of the time, the start up companies are funded by venture capitalist. Their products might still need a lot of development before reaching the marketability state.

Here, this interesting liquidity ratio, the defensive interval is able to reflect theoretically how long the company can survive or defend itself in terms of its available cash plus cash equivalent ( most liquid cash) versus its daily cash operating requirement.

Tabulate below some salient points on Defensive Interval or some called Burn Rate Ratio:

Ratio	Purpose	Formula
Defensive ratio	· Used to indicate the number of days a company could theoretically remain in business without additional sales or new loans ( financing)	Average daily cash expenditure for operating expenses ————————–Company’s most liquid assets
Note: Most liquid assets =cash + cash equivalents
Illustration: ABC Ltd: Annual operating expenses = $365,000 per annum Current cash & cash equivalents as follows: Cash 60,000 Fixed deposits less than three months 140.000 Marketable securities 100,000 300,000 Defensive ratio/Burn Rate Ratio =Average daily cash operating expenses/ Most liquid assets =$365,000/365=$1,000/365 Daily operating expenses = Annual operating expenses/365 days =$365,000/365 =$1,000,00 Defensive Interval = Average =$300,000/$1,000=300 days
Interpretation: What it means is that ABC Ltd can continue to be in business without any trade-related activity (additional sales) or new funding (new loans) for 300 days.

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Market To Book Ratio

slang — Fri, 02 Nov 2007 11:14:07 +0000

Investors and analysts will normally deploy one particular market base accounting ratio which is the Market to Book ratio or Price-to-Book Value Ratio.

This ratio expresses the relationship between a company’s value in the stock market and the net asset value as per the company’s balance sheet.

The formula is = market price per share/book value per share.

The purpose of this ratio is to indicate the value investors place on the company. To a certain extent, this ratio can reflects that the company’s assets are undervalued.

Simple illustration:

In 2006, Company A’s market price per share =$2.20

The book value of its share was $2.00

It’s market/book ratio

=$2.20/$2.00 =1.10

which means that the company’s value in the market place is 10% higher than its actual book value.

So what might this ratio reveals:

it might indicates that the company’s assets are understated/undervalued and

its prospects are good and investors believe that its earnings and value would grow

The market/book ratio summarizes investors’ views on the company’s performance and its future prospects. This is done when the investors decide the rate(price) for a business and they mark the share price at a premium or discount depending on whether the return is more or less.

More salient points:

A higher price-to-book ratio or market to book ratio is more desirable since it shows that the stock maret places a high value on the company. In some business like the banks, the book value per share may be higher than the market price per share
If investors believe that the market price of a company is too high relative to its book value, they may sell the stock; alternatively if they feel that the stock is undervalued in the market, investors will be encouraged to buy stock.

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Market Value Added (MVA)

slang — Fri, 02 Nov 2007 11:11:34 +0000

Let’s look at another useful market based ratio which is known as the Market value added ( MVA).

MVA is the difference between the market value of the company and the total capital invested in the company.

The formula of MVA is =

market capitalization ( number of equity shares issued x market price per share )

less:

net worth ( share capital + reserves – accumulated losses)

This Market value added(MVA) ratio gives us an indication of how the market perceives the company’s future EVA (economic value added). Naturally, the higher the value added, the more in demand the company’s shares.

Simple illustration:

On 30 th April 2006,Company A Ltd has the following details:

(a) 500,000 shares @ $10 each issued;

(b) market price per share =$22

To compute the MVA of Company A Ltd

firstly need to compute:

(a)Market capitalization=500,000 shares x$22 =$11.0m

(b) Net worth ( share capital($5m)+reserves($3.5m)+losses(-$2m) =$6.5m

MVA=

Market capitalization – net worth = $11.0 -$6.5m =$4.5m

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Financial Ratio To Predict A Company’s Bankruptcy Within a Two Years Period

slang — Wed, 17 Oct 2007 14:54:59 +0000

In earlier articles we have gone through many ratios to assess the liquidity, profitability, market based ratio, activity of asset utilised,gearing level and cash sufficiency of a company.

There is a very interesting ratio which can assist the managers to predict the probability of a company entering bankruptcy within a 2 year period.
That ratio is the Altman Z System. This powerful diagnostic tool uses almost the same type of financial ratio we used.

Introduction to Altman Z System:
The person who discovered this “system” is Mr. Edward Altman, who is an economist. Yes, an economist! Not surprisingly to say that as econometrics is a very advanced study of mathematics and is part of the study of Economics.
He was able to use computer simulations to study companies, in order to come up with his Z-Score Formula for Predicting Bankruptcy. The system is about 72% – 80% accurate.

It combines five (5) common business ratios, using a weightage system designed by Altman. It was originally derived based on data from manufacturing firms but this has been modified for firms in general.

Appended below are the various formulas for Altman Z-Score System:
• Formula Altman Z-Score: (PUBLIC COMPANIES)

• Working Capital X 1.2
Total Assets

• Retained Earnings X 1.4
Total Assets

• Earnings be interest & tax X 3.3
Total Assets

• Market Value of Equity X 0.6
Total Liabilities

• Sales X 0.999
Total Assets

Original Z-score for PUBLIC MANUFACTURER
3 Or > Bankruptcy is not likely
1.8 Or > Bankruptcy is likely
(Between 1.8 to 3.0 – is the gray area )
Probabilities of bankruptcy within the above ranges are 95% for 1 year
and 70% within two years.

Model a Z-score for PRIVATE MANUFACTURER
2.90 or > Bankruptcy is not likely
1.23 or < Strong indicator bankruptcy is likely
Probabilities of bankruptcy in the above ranges are 95% for 1 year
and 70% within two years.

Model a Z-score for PRIVATE GENERAL FIRM / NON MANUFACTURER
2.60 or > Bankruptcy is not likely
1.10 or < Strong indicator bankruptcy is likely
Probabilities of bankruptcy in the above ranges are 95% for 1 year
and 70% within two years.

• Formula Altman Z-Score: (PRIVATE COMPANIES)

• Working Capital X 0.717
Total Assets

• Retained Earnings X 0.847
Total Assets

• Earnings be interest & tax X 3.107
Total Assets

• Market Value of Equity X 0.420
Total Liabilities

• Sales X 0.998
Total Assets

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Cash Flow Efficiency(PartB)

slang — Wed, 17 Oct 2007 14:43:54 +0000

[GO TO THE MAIN PAGE FOR ALL ARTICLES ON CASH FLOW]

In Part A, we have looked at Cash sufficiency Financial ratio, let’s look at another cash flow ratio namely CASH FLOW EFFICIENCY FINANCIAL RATIO:

Ratios For Cash flow efficiency

(a) Cash flow to sales

Purpose: to measure the ability to convert sales revenue into cash flows.

Formula:

Cash from operations

Net sales revenue

(b) Operation Index

Purpose: an index measuring the relationship between profit from operations and operating cash flows

Formula:

Cash from operations

Operating profit after income tax

(c ) Cash flow return on assets

Purpose: to measure the entity’s operating cash flow return on assets before interest and tax.

Formula:

Cash from operations + Tax Paid + Interest paid

Average total assets

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Cash Sufficiency Of A Company(PartA)

slang — Wed, 17 Oct 2007 14:39:22 +0000

[GO TO THE MAIN PAGE FOR ALL ARTICLES ON CASH FLOWS]

We have looked at the articles:Profit Versus Cash & Accounting on Cash Basis Versus Accrual basis.We should able to understand that the vein of an organization is its cash flow. We also have reviewed the Cash Flow Statement which is an integral part of the financial statements and a very critical report to see how the company’s monies being utilized.

Here,this article showed that we can derive useful ratios from the cash flow statement to assist us to evaluate the cash sufficiency of the entity.

When we say cash sufficiency of an entity, we basically mean the adequacy of the cash flows to meet the entity’s cash needs for long-term debt payments, dividends and acquisition of non-current assets.

This should not be confused with cash flow efficiency of the entity which is really the efficiency with which the entity generates cash from its revenues, profits and assets.

Let’s look at the ratios for Cash flow namely :

CASH SUFFICIENCY RATIO(PARTA) and

Cash flow Efficiency(PartB)

Ratios For Cash Sufficiency

(a) Cash flow adequacy:

Purpose: to measure the entity’s ability to cover its main cash requirements

Formula:

Cash from operations

Long term debt paid + Assets Acquired + Dividends paid

(b) Long-term debt repayment

Purpose: to measure the entity’s ability to cover its long term debt out of cash from operations

Formula:

Long term debt repayments

Cash from operations

(c ) Dividend payment

Purpose: to measure the entity’s ability to cover its dividend payments.

Formula:

Dividends paid

Cash from operations

(d) Reinvestment

Purpose: to measure the entity’s ability to pay for its non-current assets out of cash from operations

Formula:

Non-current asset payments

Cash from operations

(e) Debt Coverage

Purpose: to measure the payback period for coverage of long-term debt.

Formula:

Total long-term debt

Cash from operations

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Know When A Company Is Overcapitalized (Part5of5)

slang — Mon, 15 Oct 2007 06:34:24 +0000

Vice Versa to Part 4 where we can see whether a company is undercapitalized, this article is of interest to managers who might feel that a company has been ovecapitalized. Try looking at the following tell-tales/symptoms:

WHEN DO YOU CONSIDER AN ENTITY BECOMES OVERCAPITALIZE?

Generally, an entity is said to be overcapitalized when it has fixed assets in excess of its actual needs

and

A reasonable return is not being earned on the investments of these fixed assets

Sometimes, we might consider an entity overcapitalize when it has substantial amounts of intangibles represented by inflated values like in the case of patents, trademark, good will and other deferred assets. Hence instead of looking at the shareholder funds alone, there is a need for the deduction of these intangibles assets from the shareholder fund to get the real tangible worth of the entity.

SOME OF THE TELL-TALES OR SYMPTOMS OF OVERCAPITALIZATION

High proprietary ratio ( refer to my previous article on this)

Low earnings per share

Low assets utilization particularly with a lot of fixed assets and small revenue generated

Too much capital invested in unproductive fixed assets

SALIENT POINT TO NOTE

With overcapitalization, management needs to cut the cloth to a smaller piece to generate higher earnings. This is by reducing the share capital ( court proceeding), disposal of idling fixed assets and business reengineer to increase its revenue streams.

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Know When A Company Is Undercapitalized (Part4of5)

slang — Mon, 15 Oct 2007 06:31:45 +0000

In earlier articles(Part1, 2, & 3) on gearing/borrowing/leverage financial ratios, append below further information on when you can see that a company is undercapitalized or not

WHEN DO YOU CONSIDER AN ENTITY BECOMES UNDERCAPITALIZE?

Opposite of overcapitalization.
Undercapitalization would mean that the entity has not sufficient capital to provide for its own scale of operations.
Evidenced by high borrowings from trade creditors or bank borrowings

Undercapitalization can be a result of Overtrading:

-can be due to over-ambitious expansion of business by increasing revenues but without insufficient funding from the shareholders themselves. Substantial investments might be made on fixed assets like plant and machinery while the company does not have adequate shareholders’ equity ( capital, retained earnings, reserves) hence over-relying on liabilities as the funding source.

[ Refer to a more detailed article on OVERTRADING ]

SOME OF THE TELL-TALES OR SYMPTOMS OF UNDERCAPITALIZATION

Very low current ratio ( inability to pay current liabilities using its current assets)
Very low proprietary ratio ( shareholders’ equity is very small compared to total assets)
Too high an earnings per share ratio ( high net profits)

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