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Bankruptcy prediction – Z score Distanced from Default Prediction

, November 24, 2015, 0 Comments

bankruptcy-financial-health-marketexpress-inBankruptcy prediction was made easy by the use of Altman Z score for more than four decades now. Way back in 1968 that was quite significant, especially since the industry was having mostly manufacturing companies. However, as the pattern of industry changed over the last 60 years with the emergence of services (especially IT driven), the mode of doing businesses have taken a complete U-turn in terms of capital structure and methodology; the importance of Z score got diminished rapidly. Recently it has been found to be replaced by Distance to Default Method. It is found significantly accurate over Z score calculations.

For public companies, the z-score is calculated as follows: 1.2*T1 + 1.4*T2 + 3.3*T3 + 0.6*T4 + 1.0*T5.

  1. T1 = Working Capital / Total Assets. This measure liquid assets as firm in trouble will usually experience shrinking liquidity.
  2. T2 = Retained Earnings / Total Assets. This indicates the cumulative profitability of the firm, as shrinking profitability is a warning sign.
  3. T3 = Earnings Before Interest and Taxes / Total Assets. This ratio shows how productively a company in generating earnings, relative to its size.
  4. T4 = Market Value of Equity / Book Value of Total Liabilities. This offers a quick test of how far the company’s assets can decline before the firm becomes technically insolvent (i.e. Its liabilities exceed its assets).
  5. T5 = Sales/ Total Assets. Asset turnover is a measure of how effectively the firm uses its assets to generate sales.

Z Score below 2.99 -“Safe” Zones. The company is considered ‘Safe’ based on the financial figures only.

1.8 < Z < 2.99 -“Gray” Zones. There is a good chance of the company going bankrupt within the next 2 years of operations.

Z below 1.80 -“Distress” Zones. The score indicates a high probability of distress within this time period.[1]

So, it clearly signifies that high working capital, high retained earnings, higher EBIT, high market value of equity and high sales will ensure a high level of Altman Z score. Back in 1968, it was made for manufacturing giants following traditional finance techniques. So, even till 1990s, it used to predict 80% possible bankruptcy with conviction.

Now, no company wastes money in working capital, even for a week also, they invest in seven days Cash Management Bills (GOI), which are based on Marginal Standing Facility (MSF). Companies do not retain earnings instead they grow business with that and pay incentives for higher sales in the future. Companies prefer debt, whether public or private, even mezzanine too. WACC comes down, and it helps to plan and schedule cash flows with more conviction.

Sales and EBIT still are going to be on the higher side; even mass producers are not bothered often about. They focus on the market share at any cost. E Commerce and services companies do not believe in equities,; startups and SMEs are going through debt route at the beginning itself to streamline their outflows against servicing the debt. Cash flow management and lowering of operating income has taken the limelight, and slowly but steadily Altman Z score is losing its sheen. Businesses are running on, low to no inventory nowadays. So, the use of the famous Z score will now be limiting its wings only in the large scale manufacturing sector. Even medium to small scale companies, do not tend to keep inventory and do not keep unnecessary working capital.

They are moving labourers from daily to monthly wages, so that the funds could be deployed in CMBs for that period to earn an additional buck. Also plenty of Private Limited Companies, which are almost 50% or more in the quantum of business in India, could not be predicted with the use of this Z score. As most new companies will be working on a private debt setup, so the EBIT will be less. Profits will go as a loan to a sister concern. Banking in India has to keep statutory 30% (approx.) as Bonds or Gold with the Central; Bank for SLR & CRR purpose. Lending book determines the profitability of the Bank. So, Z score fails to predict that too.[2]

There are alternative to the Z score model which is relatively more accurate in predicting possible situations of near bankruptcy. One method is Univariate in nature, with a name LTA that is Total Liabilities by Total Assets. Another emerging method from the recent past is the Distance to Default method, which is a modified structural model quite similar in nature with the Black-Scholes-Merton Model.

Z score has an accurate ratio of 0.6 or 60% compared to 70% by Distance to Default Method, developed by the Centre for Research in Security Prices by University of Chicago along with Morningstar. Another similar method TL/A is as accurate as Z score with 60% accuracy. Z score seems to be performing poorly where the probability of bankruptcy has been significantly higher.

In Distance to default, as the option pricing formula has been used expected asset value at a future time could be calculated and compared to the future debt balance value to. Currently post using this model the accuracy of bankruptcy prediction has breached 75%. As most firms nowadays are highly leveraged and mostly work on borrowed money to keep the WACC as low as possible, so the accounting based Z score model could not identify the gaps and accuracy of prediction suffers.

[1] http://www.readyratios.com/reference/analysis/altman_z_score.html
[2] http://corporate.morningstar.com/us/documents/MethodologyDocuments/MethodologyPapers/CompareModelsCorporateBankruptcyPrediction.pdf