If you really want to measure your company's performance, you should try calculating its Z score.
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.
