# Using Z-Score Predictor

The media reports we’re experiencing the most unusual economy in 40 years. Interest rates are low, however banks are reluctant to lend; hence stalling the contribution of our nation’s small businesses. A growing percentage of home owners are upside down on their mortgages and struggling to find the motivation to pay their debt since there appears to be no benefit to them. Education costs are exorbitant and our students are saddled with school debt. Unemployment is 11%. Although these trends have been developing for years, businesses and consumers alike ignored the facts and continued to spend freely. What is there to learn from the wisdom of 40 years ago and how can we apply it to the reality of today’s situation?

What is there to learn from the wisdom of 40 years ago and how can we apply it to the reality of today’s situation?

Altman’s Z-Score Insolvency Predictor

Edward Altman (1941 – ) presently Max L. Heine Professor of Finance at the Stern School of Business, New York University created the Altman Z-Score in 1968. Professor Altman combined a set of 5 financial ratios to determine, with tremendous accuracy, which businesses would flourish and which businesses could be headed for bankruptcy.

The Z combines a set of five financial ratios. It uses statistical techniques to predict a company’s probability of failure using eight variables from a company’s financial statements.

The Z-Score formula can be applied to publicly traded competitors, acquisition candidates, suppliers, customers, and other companies of interest. The Z-Score may also be useful for establishing trends in the financial condition of your own company. Sometimes a Z-Score analysis is needed to convince management and board of directors of the seriousness of a company’s condition so that turnaround efforts can be initiated.

Here are the 5 ratios and their respective weight factors:

 Ratio Weight A Net Sales/Total Assets (simple measure of capital turnover using annual sales) 1.0 B Earnings Before Interest and Taxes (EBIT)/TotalAssets (referred to as return on capital employed, this ratio incorporates all capital employed, both debt and equity) 3.3 C Working Capital/Total Assets (the difference between current assets and current liabilities divided by the total book value) 1.2 D Retained Earnings/Total Assets (this ratio is lower for younger companies since retained earnings accrue over the lifetime of a company; this penalty for youth reflects the higher probability of failure among younger companies) 1.4 E Market Value of Equity/Total Liabilities (stock market capitalization for all classes of stock is used in this ratio) .6

Each ratio is then multiplied by its weighting factor and summed to calculate Z:

Z = (1.0)A + (3.3)B + (1.2)C + (1.4)D + (.6)E

Scores below 1.81 indicate a high likelihood of bankruptcy. Scores above 3.00 indicate a low likelihood of failure. Scores in the middle of this range are not clear indicators, but they are less likely to be associated with failure than low scores.

Repeat the analysis periodically and plot Z scores for companies of interest on a graph with Z scores on the vertical axis and time on the horizontal. Significant downward trends in Z scores signal a potential problem, and even if the Z score does not fall below 1.81 the source of the problem should be identified and evaluated. Look at trends within the component ratios to see why the Z score is falling and decide whether it represents a serious problem.

For Privately Held Companies

If you want to analyze a company that is not publicly traded, you will not be able to compute ratio E for the Z score formula. Many companies use smaller suppliers and sell to smaller customers that are privately held. Although Altman did not extend his study to these companies, the other 4 ratios can be computed from D&B reports and a partial Z computed by dropping E. The resulting measure will tend to be lower than the standard Z score. It is best used as a long-term tracking device, with significant declines considered a flag requiring closer scrutiny.

Interested in a Z-Score analysis for your company, customer base, public or privately held competitors, or potential acquisition target? We can conduct an analysis, allowing you to make informed decisions for a reasonable flat rate. Please give me a call at 630.778.7646 or email me at jlafferty@cfo-pro.comto discuss.

The Wisdom of Henry Hazlitt (1894 – 1993)

It is exports that pay for imports, and vice versa. The greater exports we have, the greater imports we must have, if we ever expect to get paid. Without imports we can have no exports, for foreigners will have no funds with which to buy our goods.

The clearing house for these transactions is known as foreign exchange where, in America, the dollar debts of foreigners are cancelled against their dollar credits. In England, the pound sterling debts of foreigners are cancelled against their sterling credits.

This mechanism does not differ essentially from what happens in domestic trade. Each of us must also sell something, even if for most of us it is our own services rather than goods, in order to get the purchasing power to buy. Domestic trade is also conducted in the main by crossing off checks and other claims against each other through clearing houses.

Among the arguments put forward in favor of huge foreign lending one fallacy is always sure to occupy a prominent place. It runs like this. Even if half (or all) the loans we make to foreign countries turn sour and are not repaid, this nation will still be better off for having made them, because they will give an enormous impetus to our exports.

It should be immediately obvious that if the loans we make to foreign countries to enable them to buy our goods are not repaid, then we are giving the goods away. A nation cannot grow rich by giving goods away. It can only make itself poorer. No one doubts this proposition when it is applied privately.

If this proposition is so simple when applied to a private company, why do apparently intelligent people get confused about it when applied to a nation? The reason is that the transaction must then be traced mentally through a few more stages. One group may indeed make gains—while the rest of us take the losses.

The U.S. government has been engaged for years in a “foreign economic aid” program the greater part of which has consisted in outright government-to-government gifts of many billions of dollars. What conceals the truth from many supporters of the program is that what is directly given away is not the exports themselves but the money with which to buy them. It is possible, therefore, for individual exporters to profit on net balance from the national loss—if their individual profit from the exports is greater than their share of taxes to pay for the program.

The real gain of foreign trade to any country lies not in its exports but in its imports. Its consumers are either able to get from abroad commodities at a lower price than they could obtain them for at home, or commodities that they could not get from domestic producers at all. Outstanding examples in the U.S. are coffee and tea. Collectively considered, the real reason a country needs exports is to pay for its imports.

— Paraphrased From Economics in One Lesson (1946)