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How Are You Doing?

Someone once said that if you have one clock, you always know what time it is, but if you have several clocks, you are never quite sure. I often get tht feeling when I calculate financial ratios. This is because the dozens of financial ratios I use seem to provide different answers to the same simple question, 'How'd we do?"

So I've been on the lookout recently for financial models that summarize one general aspect of overall company performance. An example is the affordable-growth rate (see Finance, "How Fast Is Too Fast?" INC., December 1986), which tells you the maximum rate your company can afford to grow without having to increase its debt ratio. Another is the Z score, which, though developed to measure the likelihood of bankruptcy, can be used as a handy measure of overall financial performance.

The original Z score was created by Edward I. Altman in the mid-1960s. It is the most widely used of the many bankruptcy classifications that exist, and it has stood the test of time. To arrive at his formula, Altman looked at the financials of 66 publicly traded manufacturers: 33 had filed for bankruptcy; 33 had not. Out of a selection of 22 financial ratios, he found 5 that could be combined to discriminate between the bankrupt and the nonbankrupt companies in his study. Later, Altman created what he calls the four-variable version (see Figure 1). Also widely used, this version is appropriate for both public and private firms, and for both manufacturers and service companies.

FIGURE 1

The Z Score Bankruptcy Classification Model

Mean Ratio Values

Altman's Sample Cos.

Ratio

Names Description Coefficient Bankrupt Nonbankrupt

X1 = Working Capital / Total Assets 6.56 (0.061) 0.414

X2 = Retained Earnings / Total Assets 3.26 (0.626) 0.355

X3 = EBIT / Total Assets 6.72 (0.318) 0.154

X4 = Net Worth / Total Liabilities 1.05 0.494 2.684

Cutoff Values Mean Scores

Safe if greater than: 2.60 Nonbankrupt 7.70

Bankrupt if less than: 1.10 Bankrupt (4.06)

Source: Corporate Financial Distress, by Edward I. Altman; John Wiley & Sons, 1983.

To get the Z score, you simply take the figures for the four ratios, which Altman calls X1, X2, etc., from your financial statements. Multiply their values by coefficients Altman has derived, and add up the results. The formula, explained in detail below, looks like this:

6.56(X1) + 3.26(X2) + 6.72(X3) + 1.05(X4).

If a company's total score is greater than 2.60, things are looking good. If it is less than 1.10, bankruptcy may well be in sight. Figure 2 shows the financial statements and Z-score calculations for a hypothetical company, the BC Corp., which, at 5.206, has scored well above the danger point.

The interesting thing about the Z score is that it is a good analytic tool no matter what shape your company is in. Even if your company is very healthy, for example, if your Z score begins to fall sharply, warning bells should ring. Or, if your company is barely surviving, you can use the Z score to help evaluate the projected effects of your turnaround efforts.

To find your company's Z score, first calculate the four ratios.

X1 = Working Capital / Total Assets

This measure of liquidity compares net liquid assets to total assets. The net liquid assets, or working capital, are defined as current total assets minus current total liabilities. Generally, when a company experiences financial difficulties, working capital will fall more quickly than total assets, causing this ratio to fall.

X2 = Retained Earnings / Total Assets

This ratio is a measure of the cumulative profitability of your company. To some degree, the ratio also reflects the age of your company, because the younger it is, the less time it has had to build up cumulative profits. This bias in favor of older firms is not surprising, given the high failure rate of young companies.

When a company begins to lose money, of course, the value of total retained earnings begins to fall. For many companies, this value -- and the X2 ratio -- will become negative.

X3 = EBIT / Total Assets

This is a measure of profitability, or return on assets, calculated by dividing your firm's EBIT (earnings before interest and taxes) for one year by its total assets balance at the end of the year.

You can also use it as a measure of how productively you are using borrowed funds. If the ratio exceeds the average interest rate you're paying on loans, you are making more money on your loans than you are paying in interest. In Figure 1, for example, you can see that nonbankrupt firms earned 15.4% on their total assets before payment of interest and taxes. Since this performance exceeded the average interest rates at the time, nonbankrupt firms profited, on average, from every borrowed dollar they invested in assets. Failed firms, on the other hand, were losing 31.8% on total assets yearly. Even before they paid their interest costs, in other words, the bankrupt companies were losing nearly 32? on each dollar they borrowed.

To calculate this ratio in the middle of a fiscal year, use your month-end balance sheet and the EBIT from an income statement showing the most recent 12 months of activity. (It takes extra effort to maintain this moving 12-month income statement, of course, but you probably will find that the statement provides a view of your business that is valuable in its own right.)

X4 = Net Worth / Total Liabilities

This ratio is the inverse of the more familiar debt-to-equity ratio. It is found by dividing your firm's net worth (also known as stockholders' equity) by its total liabilities. Notice in Figure 1 that nonbankrupt firms maintained more than twice as much equity as debt -- 2.684; failed firms managed to accumulate more than twice as much debt as equity -- 0.494.

After you've calculated these four ratios, simply multiply the X1 ratio by its coefficient, shown in Figure 1, the X2 by its coefficient, and so on; add the results; and then compare the total with Altman's cutoff values, also shown in Figure 1.

The BC Corp. in Figure 2, as we've seen, scored 5.206. Since this Z score significantly exceeds the cutoff value of 2.60 shown in Figure 1, the company is safe from bankruptcy, at least for now. Suppose, instead, that its score had been minus 2.70. This would say that its financial statements strongly resemble those of companies that have gone bankrupt. If the score had been 1.70, the company would be in a gray area: companies with higher scores have gone bankrupt, while companies with lower scores have survived.

FIGURE 2

BC Corp.

Balance Sheet,

December 1986

(All values in $1,000)

Assets

Current Assets

Cash 13

Receivables 109

Inventory 272

Prepaid Expenses 9

Total Current Assets 403

Net Fixed Assets 169

Total Assets 572

Liabilities

Current Liabilities

Accounts Payable 82

Notes Payable 50

Other Current Liabilities 35

Total Current Liabilities 167

Long-Term Debt 130

Total Liabilities 297

Stockholders' Equity

Common Stock 110

Retained Earnings 165

Net Worth 275

Total Liabilities and Equity 572

BC Corp.

Income Statement,

1986

(All values in $1,000)

Sales 845

Cost of Goods Sold

Materials 250

Direct Labor 245

Utilities 32

Indirect Labor 28

Depreciation 31

Total Cost of Goods Sold 586

Gross Profit 259

Operating Expense

Selling Expenses 99

General and Administrative

Expenses 110

Total Operating Expense 209

Earnings Before Interest and Taxes 50

Interest Expense 14

Earnings Before Taxes 36

Taxes 8

Net Income 28

Stock Data, December 31, 1986

Stock Price (in dollars) 3

Shares Outstanding 100

Market Value of Equity 300

Z Score Calculations

Coeffi-

Ratio Description Formula Result cient Z Score

X1 Working Capital / Total Assets 403-167 / 572 = 0.413 X 6.560 = 2.707

X2 Retained Earnings / Total Assets 165 / 572 = 0.288 X 3.260 = 0.940

X3 EBIT / Total Assets 50 / 572 = 0.087 X 6.720 = 0.587

X4 Net Worth / Total Liabilities 275 / 297 = 0.926 X 1.050 = 0.972

Z Score: 5.206

The purpose of calculating your own Z score is to warn you of financial problems that may need serious attention and to provide a guide for action. If your Z score is lower than you would like, then, you should examine your financial statements to determine the reason why.

Start by calculating the scores from previous periods, comparing them with your current score. (Graph them if possible.) If the trend is down, try to understand what has changed to create ratios that are dragging your scores down. Monitoring the trend in your Z scores can also help you evaluate your turnaround efforts.

Another way to analyze your score is to compare your results with those of other companies. Figure 1 shows the mean (average) ratio values that Altman found for bankrupt firms in his study. Compare these ratios with your own. You could also refer to the Robert Morris Associates (RMA) Annual Statement Studies. These studies, to which your banker probably subscribes, provide detailed financial ratios by Standard Industrial Classification code. (Ratio X2 cannot be calculated from RMA data, however, because retained earnings aren't included.) Compare your own calculations with industry ratios, and find the ones that are out of line.

When your make this comparison, however, I've found it's very natural to excuse low ratios by saying, "We're different." Suppose, for example, that your X3 ratio is lower than your industry average. You might say, "We've made a much greater investment in production equipment than our competitors, giving us an advantage." But if this additional investment provides a truly competitive advantage, the other ratios should more than compensate for the low X3 ratio. If not, your competitors may actually have the advantage because they are able to achieve similar profits with a smaller investment in assets and correspondingly smaller debt.

The Z score, you will soon learn, takes a very stern view of your financial statements. To the Z score, profits are good, assets are bad, liabilities are worse, and current liabilities are worst of all. If yours is lower than you would like, you can improve it considerably by selling marginal assets and using the cash to reduce current liabilities. This will improve ratio X1 by both increasing working capital and decreasing assets; it will improve ratios X2 and X3 by reducing assets; and it will improve ratio X4 by reducing liabilities.

In real life, of course, this action can also make perfect sense. Reducing current liabilities often lowers interest costs and reduces the possibility that an unhappy creditor will force you into bankruptcy. Reducing assets can often lower overhead costs and improves your return on the assets invested in your company.

When you use bankruptcy classification models, including the Z score, keep this reservation in mind: they are by no means infallible. The fact is, one doesn't necessarily agree totally with another. The models can provide valuable warnings of trouble and useful guides to ways of avoiding trouble ahead. And they can complement the other reports and analyses that you use within your company. Seldom, however, should you use any of the models as your only means of financial analysis.