Your Money: Use Altman Z score to sniff out bankruptcy potential

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May 24, 2021 2:30 AM

If the Z score is less than 1.81, the firm is a bankruptcy candidate

arnings Before Interest & Tax (EBIT) 3,500; total assets 14,000; working capital 5,000; Retained earnings 7,000; sales revenue 10,000; book value of debt 3,000; market capitalisation 50,000.arnings Before Interest & Tax (EBIT) 3,500; total assets 14,000; working capital 5,000; Retained earnings 7,000; sales revenue 10,000; book value of debt 3,000; market capitalisation 50,000.

For conservative investors, safety of the invested corpus is the priority over earning higher returns. In this context, Altman’s Z score model cand be used to assess the financial performance of a firm.

Hypothetical illustration
Let us look at Aviral Tarun Ltd’s data (amount in Rs crore): Earnings Before Interest & Tax (EBIT) 3,500; total assets 14,000; working capital 5,000; Retained earnings 7,000; sales revenue 10,000; book value of debt 3,000; market capitalisation 50,000.

Altman Z Score
Altman developed Z score as a tool for predicting the bankruptcy of a firm. Z score is computed as the sum of 1.2 (working capital/total assets) +1.4 (retained earnings/total assets) +3.3 (EBIT/total assets) +0.6 (market value of equity/book value of debt) +0.999 (sales/total assets). Higher the score of a firm in these variables, the better is its safety margin for investors. If the Z score is less than 1.81, the firm is a bankruptcy candidate; if Z score is above 2.91, it is out of the bankruptcy risk; if Z score is 1.81-2.91, it is in the gray zone and it is difficult to predict its bankruptcy possibility.

Working capital/total assets
For AT, it is 0.36 times (Rs 5,000 crore/ Rs 14,000 crore). If its previous period ratio is 0.30 times, then the firm has improved its performance in the current year. The weighted score is 0.43 (= 1.20 * 0.36).

Retained earnings /total assets
For AT, it is 0.50 times (Rs 7,000 crore/Rs 14,000 crore). If its previous period ratio is 0.40 times, the firm has improved its performance in the current year. The weighted score is 0.70 (= 1.40 * 0.50).

EBIT/total assets
It is computed by dividing the operating profit by the total assets of a firm. For AT, it is 0.25times (Rs 3,500 crore/ Rs 14,000 crore). If its previous period ratio is 0.30 times, then the firm has fallen in its performance in the current year. The weighted score is 0.83 (= 3.30 * 0.25).

MV of equity/BV of debt
It is computed by dividing the MV of equity by the book value of debt of a firm. For AT, it is 16.67 times (market cap of Rs 50,000 crore/ BV of debt of Rs 3,000 crore). If its previous period ratio is 14 times, then the firm has improved in its solvency position in the current year. The weighted score is 10 (= 0.60 * 16.67).

Sales/total assets
For AT, it is 0.71times (sales revenue of Rs 10,000 crore/ total assets of Rs 14,000 crore). If its previous period ratio is 0.67 times, then the firm has improved its performance in the current year. The weighted score is 0.71 (= 0.999 * 0.71).

The Z score of AT is 12.67 which indicates it is a safer firm for investors. Though the coefficients may change if we run the model using current data, the inter and intra comparison of a firm in these five variables may speak volumes about the financial performance of a firm.

 

The writer is associate professor of Finance at XLRI – Xavier School of Management, Jamshedpur

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