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
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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=$1,100
Proposed solution:
Computation using the Altman Z-score model formula:
Z=X1=400/2000 *1.2=0.240 + X2=750/2000*1.4=0.525 + X3=266/2,000*3.3=0.439+ X4=1,425/1,100*0.6=0.777 + X5=3,000/2000*0.999 =1.499 =3.480
Conclusion:
Since the score is 3.480 Company XYZ falls into the guidelines/classification of “UNLIKELY” zone which means that there is no change that XYZ will go into bankruptcy within the next two years.
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More salient points on Altman Z-score model:
- Many found this model is quite accurate re:#90% accurate in forecasting business failure on year into the future and about #80% accurate in forecasting it two years into the future
- With the present global credit crunch, it enable the user to predict with reasonable accuracy whether a company is in increasing financial distress so that protective actions like curtailing capital expansion, reducing dividend pay-out or refinancing short term to long term banking structure or facility,etc
- Note that this model can be used for a group of companies.
Listed below are all the topics on Balanced Scorecard:
Append below are some examples of the Internal Process Perspective KPI:-
- On-Time Delivery
- Administrative expense/total revenues(%)
- Administrative expense/customer($)
- Average Lead Time(No)
- Contracts filed without error (No)
- Lead time, product development(No)
- Lead time, from order to delivery (No)
Append below are some examples of the Customer Perspective KPI:-
- Employee participation
- Training hours per employee
- Average years of service
- Absenteeism
- Turnover rate
- Employee suggestions
- Employee satisfaction index(No)
- Employee’s view(empowerment index)(No)
- Shareof employees below age X(%)
- Non-product-related expense/customer/year($)
- Ratio of new products(less than X years old) to full company catalogue(%)
- Near misses
- Accidents
- Value added per employee
- Diversity rate
- Work – Life Balance
- Employee productivity
- Cross – training
- Health promotion
- Personal goal achievement
- Leadership development
- Knowledge management
- Ethics violations
- Cross-functional assignments
- Problem solving teams
- Learning rate
- R&D expense($)
- R&D expense/total expenses(%)
- IT Development expense/IT expense(%)
- Hours, R&D(%)
- R&D resources/total resources(%)
- Investment in training/customers(No)
- Investment in research($)
- Investment in new product support and training ($)
- Investment in development of new markets($)
- Direct communications to customers/year(No)
- Patents pending(No)
- Average age of company patents(No)
- Suggested improvements/employee(No)
Append below are some examples of the Customer Perspective KPI:-
- Total assets($)
- Total assets/employee($)
- Revenues/total assets(%)
- Revenues from new products or business operations($)
- Revenues/employee($)
- Profits/total assets(%)
- Profits from new products or business operations($)
- Profits/employees($)
- Return on net assets($)
- Return on total assets(%)
- Return on capital employed(%)
- Return on equity (%)
- Return on Investment(%)
- Cash flow ($)
- Return on investment (%)
- Total costs($)
- Revenue($)
- Gross Margin($)
- Net Income($)
- Profit as % of sales
- Economic Value Added
- Compound Growth Rate
- Dividends
- Market Value
- Share Price
- Earnings per share
- Credit rating
- Debt
- Debt to equity
- Accounts receivable turnover
- Days in Inventory
Append below are some of the balanced scorecard examples of the Financial Perspective (KPI):-
- Annual sales/customers($)
- Average custome size($)
- Customer rating(%)
- Average time from customer contact to sales response(No)
- Average time spent on customer relations(No)
- Customers/employee ( No or %)
- Satisfied-customer index(%)
- Customer-loyalty index(%)
- Market Share
- No of Customer Complaints
- Return Rates
- Response Time
- Cost/customer($)
- Customers Lost(No or %)
- Customer retention
- Number of customers
- Annual sales per customer
- Marketing cost as a % of sales(%)
- Marketing expenses($)
- Number of proposals made
- Brand-image index (%)
- Response rate
- Sales volume
- Sales per channel
- Average customer size
- Customers per employee
- Frequency of sales transactions
- Sales closed/sales contacts(%)
- Number of visits to customers(No)
- Service expense/customer/year($)
It is important to understand the key or critical success factors for the Balanced Scorecard system to be successful:
- The leader/top management/board should walk the talk and utilizes the scorecard regularly in reviewing performance and in making plans for the future.
- The Balance Scorecard system should be used on its day-to-day use throughout all levels of the organization.
- Every individual should be aware and able to understand the importance of the performance measures and the relationship of the scorecard to the organization’s mission.
- Human Resources Department should ensure that the staff and management’s individual evaluations and compensation are linked from the organization’s performance to the balanced scorecard.
- Wrong selections of measures or having numerous measures for each perspective of a Balanced Scorecard
- When establishing the various perspectives key performance indicators, the objective is actually not to have numerous measures/metrics/kpi for each category/perspective but rather to select those few that best inform an organization when its operations are aligned with its mission and where to focus its attention and resources.
Looking merely at the financial aspects namely the final results will not be able to resolve the challenges faced by an organization.
The balanced scorecard looks at the following four fundamental performance areas of an organization and set major/crucial measures/matrix/key performance indicators for them:-
1. Financial performance
2. Customer satisfaction
3. Internal operations
4. Learning and innovation
By taking such integrated approach, the Balanced Scorecard is able to balance the vision and mission of the organization with everyday operations. In simple term, a strategic scorecard can help an organization identify the few core functions that translate its vision into reality.
Below explain each performance areas with its relevant measures and its purposes:-
FINANCIAL/MARKET MEASURES
- To inform an organization the results of actions already taken and whether those actions are contributing to its bottom line ( see examples of such measures)
CUSTOMER SATISFACTION MEASURES
- To inform an organization how it is performing in the eyes of the customer (see examples of such measures)
INTERNAL PROCESS/OPERATIONAL MEASURES
- To inform an organization about what it must do internally to meet customer and financial expectations. ( see examples of such measures)
LEARNING AND INNOVATION MEASURES
- Inform the organization on its capacity to continually innovate, improve, and sustain itself.(see examples of such measures)
Append below the following sources or references where we are able to obtain the necessary matrix measures for the four components of the Balanced Scorecard:
| FINANCIAL | CUSTOMER |
| • Annual report
• Performance reports • Analyst reports • Benchmark reports |
• Customer complaints
• Marketing/Sales Dept • Performance reports • Benchmark reports |
| INTERNAL PROCESS | LEARNING & GROWTH |
| • Operational reports
• Manufacturing reports • Benchmark data • Competitor data • Project plan |
• Human Resources data
• Core values • Benchmark reports • Consulting studies |
Balanced Scorecard is a useful management tool for charting the company’s Strategic management system/process. Besides, it is also deployed for the business’s Measurement system and as Communication Tool.
Also, those companies which set up Balanced Scorecard are able to service the customers better due to the following reasons:-
- knowing customer expectations “up front”,
- establishing strategies and goals consistent with these expectations,
- translating these strategies and goals into achievable action plans,
- providing goals that can be measured.
Balanced Scorecard is a useful tool for all level of management in terms of:-
- For top management- the company’s vision and mission need to be formulated before any other strategies can evolve ( using SWOT analysis)
- All level of management are able to specifically understand performance management re: on what are really key performance areas and key performance indicators
- When automated, where the Balanced Scorecard have been set, it helps to communicate to all personnel whichever level of hierarchy the company’s common goals/strategy to achieve or enhance shareholder value.
What is important to understand is that the Balanced Scorecard are applicable to individual department or even project and not necessarily on the company alone.
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