Z score Analysis:

Edward I. Altman, Professor and Vice-Director of New York

University's Salomon Center, Leonard N. Stern School of Business. Dr. Altman is
known as the founding father of using statistical techniques to predict company
failure. He developed the Z-Score analysis almost 30 years ago, and is the
author of several books, including The Z-Score Bankruptcy Model: Past,
Present, and Future (New York: John Wiley & Sons, 1977), and Corporate
Financial Distress and Bankruptcy, 2nd edition (New York: John Wiley & Sons,
1993).
The Analysis: The Z-score was developed from an analysis of 33 Chapter X-
bankrupt manufacturing companies with average assets of $6.4 million, and, as
controls, another 33 companies with assets between $1 million and $25 million.
Altman's Z-score calculates five ratios:
1. return on total assets,
2. sales to total assets,
3. equity to debt,
4. working capital to total assets, and
5. retained earnings to total assets.
These ratios are then multiplied by a predetermined weight factor, and the results
are added together. The final number--the Z-score--yields a number between -4
and +8. Financially-sound companies show Z-scores above 2.99, while those
scoring below 1.81 are in fiscal danger, maybe even heading toward bankruptcy.
Scores that fall between these ends indicate potential trouble. In Altman's initial
study of 33 bankrupt companies, Z-scores for 95 % of these companies pointed
to trouble or imminent bankruptcy.
Although the numbers that go into calculating the Z-score (and a company's
financial soundness) are sometimes influenced by external factors, it provides a
good quick analysis of where your company stands compared to the competition,
and a good tool for analyzing the ups and downs of your company's financial
stability over time.

Check your Z-Score:

How's your Fiscal Fitness? Routinely used by Stockbrokers trying
to determine if a company is a good investment, Bankers to determine loan risk,
and internally, by anyone who wants to take close look at his or her own
company's financial health.

Data Needed:

 Earnings before taxes

 Total assets
 Net Sales
 Market Value of Equity
 Total Liabilities
 Working Capital
  Retained Earnings

WEIGHT
RATIO FORMULA WEIGHTED RATIO
FACTOR

Earnings Before Interest and

Return on
Taxes
Total x. 3.3 -4 to +8.0
-----------------------------------------
Assets
Total Assets

Sales to Net Sales

Total ----------------------------------------- x 0.999 -4 to +8.0
Assets Total Assets

Market Value of Equity

Equity to
----------------------------------------- x 0.6 -4 to +8.0
Debt
Total Liabilities
Working
Working Capital
Capital to
----------------------------------------- x 1.2 -4 to +8.0
Total
Total Assets
Assets
Retained
Retained Earnings
Earnings
----------------------------------------- x1.4 -4 to +8.0
to Total
Total Assets
Assets

MDA(Multiple Discriminant Analysis) is a statistical technique used to classify an

observation into one of several a priori groupings dependent upon the
observation's individual characteristics. It is used primarily to classify and make
predictions in problems where the dependent variable appears in qualitative
form, for example, bankrupt or non bankrupt. Therefore the first step is to
establish group classifications.
After the groups are established, data are collected for the objects in the groups.
MDA in its most simple form attempts to derive a linear combination of these
characteristics which "best" discriminates between the groups.If a particular
object,for instance, a corporation, has characteristics(financial ratios) which can
be quantified for all the companies in the analysis the MDA determines a set of
discriminant coefficients. When these coefficients are applied to the actual ratios,
a basis for classification into one of the mutually exclusive grouping exists.
The discriminant function of the form Z= V1X1 + V2X2 +...+VnXn transforms the
individual variable values to a single discriminant score , or Z value, which is then
used to classify the object where V1,V2,...Vn = discriminant coefficients
X1,X2....Xn = independent variables
The Z-Score model is a linear analysis in that five measures are objectively
weighted and summed up to arrive at an overall score that then becomes the
basis for classification of firms into one of the a priori groupings(distressed and
non distressed).

After initial groups are defined and firms selected, balance sheet and income
statement data are collected. A list of 22 potentially helpful ratios was compiled
for evaluation and the 5 of them were finally chosen for doing the best overall job
together in the prediction.The following procedures are utilized: (1)observation of
the statistical significance of various alternative functions,including determination
of the relative contributions of each independent variable.(2)evaluation of
intercorrelations among the relevant variables(3)observation of the predictive
accuracy of the various profiles and (4) subjective judgment The ratios are
classified into five standard categories, including liquidity,
profitability,leverage,solvency,activity.
The final discriminant function is as follows:

Z= 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5

where

X1 = working capital/total Assets

X2 = retained earnings/total Assets
X3 = earnings before interests and taxes/total Assets
X4 = market value of equity/book value of total liabilities
X5 = sales/total Assets
Z = overall index

X1(Working Capital/Total Assets)

The working capital/total assets ratio is a measure of the net liquid assets of the
firm relative to the total capitalization. Working capital is defined as the difference
between current assets and current liabilities. Ordinarily a firm experiencing
consistent operating losses will have shrinking current assets in relation to total
assets.

X2(Retained Earnings/Total Assets)

Retained earnings is the account which reports the total amount of reinvested
earnings and/or losses of a firm over its entire life. The account is also referred to
as earned surplus. The RE/TA ratio measures the leverage of a firm. Those firms
with high RE, relative to TA, have financed their assets through retention of
profits and have not utilized as much debt.
X3(Earnings before Interest and Taxes/Total Assets)
This ratio is a measure of the true productivity of the firm's assets,independent of
any tax or leverage factors. Since a firm's ultimate existence is based on the
earning power of its assets, this ratio appears to be particularly appropriate for
studies dealing with corporate failure.

X4(Market Value of Equity/Book Value of Liabilities)

Equity is measured by the combined value of all shares of stock,preferred and
common,while liabilities include both current and long term.The measure shows
how much the firm's assets can decline in value before the liabilities exceed the
assets and the firm becomes insolvent.

X5(Sales/Total Assets)
The capital-turnover ratio is a standard financial ratio illustrating the sales
generating ability of the firm's assets. It is one measure of management's
capacity in dealing with competitive conditions.
The resulting Z-Score puts a company in one of three categories. Companies
with a Z-Score above 3.0 are considered healthy. A Z-Score less than 1.8
indicates a high probability for bankruptcy in the next 1-2 years. Scores of 1.8-3.0
are considered within the "gray area".
There are two revisions of the Z-Score that are designed to apply to private
companies. For public companies the original Z-score should be preferred.

The Revised Z-Score model

A complete re estimation of the model occurs by substituting the book values of
equity for the Market value in X4. All the coefficients change and the
classification criterion and related cut-off scores also change. The revised Z
score is as follows:

Z' = 0.717X1 + 0.847X2 + 3.107X3 +0.420X4 +0.998X5

This score is recommended for private manufacturing companies.

A Further Revision
The next modification of the Z-score analyzed the characteristics and accuracy of
a model without X5 - sales/total assets.We do this to minimize the potential
industry effect which is more likely to take place when such an industry sensitive
variable as asset turnover is included.The new Z score is as follows:

Z'' = 6.56X1 + 3.26X2 +6.72X3 +1.05X4

The Z'' score is recommended for private non-manufacturing companies.

Ratio Analysis
Classification of Ratios

One of the ways in which financial statements can be put to work is

through ratio analysis. Ratios are simply one number divided by
another; as such they may or not be meaningful. In finance, ratios are
usually two financial statement items that may be related to one
another and may provide the prudent user a good deal of information.
Of the myriad of ratios that could be generated, some will be more
meaningful than others. Generally ratios are divided into four areas of
classification that provide different kinds of information: liquidity,
turnover, profitability and debt.

• Liquidity ratios indicate the firm's ability to meet it maturing

short-term obligations.
• Turnover indicates how effectively the firm manages
resources at its disposal to generate sales.
• Profitability indicates the efficiency with which manages
resources.
• Debt indicates the extent to which the firm is financed by
debt.

Evaluations

Remember, ratios are just one number divided by another and as

such really don't mean much. The trick is in the way ratios are
analyzed and used by the decision maker. A good strategy is to
compare the ratios to some sort of benchmark, such as industry
averages or to what a company has done in the past, or both.

Comparisons

Once ratios are calculated, an analyst needs some benchmarks to find

out where the company stands at that particular point. Useful
benchmarks are industry comparisons and company trends.

It may be useful to compare a company to certain industry averages to

get a feel for how the company is performing. In that case it is
necessary to obtain industry performance measures. There are a
number of sources for industry figures.
• Commercial Sources – A number of companies publish
information on industry comparisons. Among these sources
are private credit reporting agencies such as Dun &
Bradstreet and Robert Morris & Associates. Rating agencies
such as Moody's and Standard & Poor's also provide industry
information.
• Government Sources – There are a number of government
sources of helpful industry information, such as the U.S.
Industrial Outlook and Quarterly Financial Reports.
• Trade Associations – Many industries have trade
associations or industry groups that regularly publish
information for and about members.