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Assessing the credit worthiness of a customer and deciding how much credit to provide a customer is very important to safeguard the interests of your business. For the safety of your business it is important that you know the credit worthiness of the prospective customer before granting credit.

The year 2002 saw approximately 191 public companies going bankrupt. If your money also has gone down with them then you are in a difficult financial crisis. Therefore, it becomes very important to understand the situation of each client before granting credit.

The year 2001 saw the highest number of bankruptcies in the history of the United States since the year 1980. The year 2002 saw the number come down to 2002 but this was still higher as compare to the average of the years from 1986-2000, which worked out to 113. This trend does not show very healthy signs and is a cause for concern.

The matter of concern is not only the number of companies that have filed bankruptcy but also the fact that most companies going bankrupt in the last few years are large companies. From the 1970s the trend of big companies going bankrupt is getting to be a common feature. The sad part is that of the 191 public companies that went bankrupt in the year 2002, 34 were companies with $1 billion worth of assets.

The following table shows the five largest bankruptcies since the year 1980(of US Public Companies), three of the bankruptcies have been reported during the last fifteen months, which is an alarming fact.

Five Largest Bankruptcies of U. S. Public Companies

Bankruptcy declared by a company can have far reaching impacts in the economy and is real bad news for those who have been having business relations with the company. If the company declaring bankruptcy is a large company then all the more reasons for panic because there would be several suppliers who totally depend on the company (especially other small businesses) and also that in case of a large company the number of individuals and other businesses affected is a large number.

The example of the bankruptcy of the company “WorldCom” is an example, which explains this phenomenon. WorldCom had contracts which went on up to the year 2006 and this definitely means that the business partners of the company would not be able to derive any kind of income from their business contracts.

This is a really serious situation for the concerned companies as many of them would have even incurred huge expenses for the execution of the contracts but there is going to be only loss for them on this count.

In such a scenario where the number of large companies declaring bankruptcy is on the rise, the professionals must see to it that a careful study about the future or prospective client is made before signing on the dotted line. The bankruptcy prediction models need to be used wisely and the results interpreted must be accurate. One of the widely used and most popular models in this field is the one proposed by Edward Altman – The Z-score model. A good understanding of the model would help make the necessary decisions based on the facts.

Z-Score Model- Edward Altman

Research has been going on for many years for deriving a ratio that would be an indicator for making predictions regarding bankruptcy. The studies by William Beaver led to the conclusion that the cash flow to debt ratio was the best suited to make predictions regarding bankruptcies.

The breakthrough in the field came with the studies and conclusions laid down by Edward Altman who instead of basing all the decisions on a single ratio decided to venture further and formulate a comprehensive statistical model which used the multiple discriminant analysis or MDA. The model helped the people using it to work out details and thus, divide the companies into two important groups based on the study namely, the companies that went bankrupt and those that did.

For this study Edward Altman chose a sample size of 33. These were manufacturing companies that had gone bankrupt during the period from 1946 and 1965 and also took another 33 companies that were chosen on a random basis.

With the aid of 22 ratios that would be of help to make bankruptcy predictions Edward Altman started his calculations. With every round of studies he kept eliminating ratios one by one. The ratios that made the least contribution in helping the studies progress were eliminated at each stage.

When all the useful ratios (which were in all 5 in number) were put together as per the MDA technique, he got a standard, which he could use, for deriving further conclusions. This was called the Z-score. The Z-score was set at 2.675 initially and companies that were below this laid down standard were the ones that belonged to the category of companies which were bankrupt or soon there and the ones which were above the standard mark were the non-bankrupt companies.

This Z-score model proved useful in his studies and Edward Altman was able to accurately point out 94% of bankrupt companies and 97% non-bankrupt that too a year before the companies declared bankruptcy. A decision making exercise to predict this two years in advance did not yield as accurate results as we was able to predict only 72% bankrupt companies and 94% non-bankrupt companies to years in advance.

The Z-score model was constructed for using in case of public manufacturing companies. Edward Altman has developed two other models namely the Z’ (for use in case of private manufacturing companies) and Z” (in case of non-manufacturing companies).

After further studies based on samples, Edward Altman lowered his standard of the Z-score from the earlier 2.675 to 1.81. A Z-score between the two was considered a “gray area” for which one could not give accurate conclusions. A company with a Z-score that fell in the “gray area” was one, which could go both ways either could go bankrupt but this could be confirmed fully.

Altman’s studies showed that in the year 1999, showed that out of the companies studied in Compustat data tapes20% had Z-scores below the standard of 1.81, which explains the high rate of bankruptcies in the year 2001-2002.

The Power of Z-score

An analysis of each of the five ratios in the Z-score model would go to prove as what makes this model or system so effective in making predictions regarding bankruptcies.

X1 (Working Capital/Total Assets): Working capital can be derived by subtracting the current liabilities from the current assets (Working Capital = currents assets- current liabilities). Current assets refer to assets that can be converted into cash in a time period of a year like cash, stock, accounts receivables and the like.
On the other hand current liabilities refer to payments in cash that have to be made within a time period of one year like accounts payable. Therefore, on calculating the working capital if you end up with a negative figure it goes to show that the company would not be in a position to meet its immediate need of cash, as the current assets are not enough to meet the current liabilities.

Alternatively, a company having a good working capital shows healthy signs as it goes to show that it would be able to make its payments on time.

X2 (Retained Earnings/Total Assets): Retained Earnings refers to the profits of the previous years that are not distributed to the shareholders as dividends. A high amount of retained earnings shows that the company has sufficient funds to fall back on. In case of losses for a short period also the company would not fall into a bad financial crisis situation. On the other hand, low retained earnings shows that any kind of loss can throw things off balance, as the company does not have sufficient funds to fall back on.
X3 (Earnings before Interest and Taxes/Total Assets): This ratio indicates the firm’s earning potential. EBIT refers to earnings before interest and taxes and this shows the income or the earnings of the company which is to be distributed between three major groups namely, the shareholders (in the form of dividends), the creditors (as principal and interest) and to the government in the form of taxes.
X4 (Market Value of Equity/Book Value of Total Liabilities): Market value of Equity or market capitalization is a ratio to determine the market value or the value of the firm in the stock market. In case of the firm going bankrupt the market value of its share is going to dip drastically, thus, a high market value indicated the public confidence in the financial position of the company.
If a stock has a high market value then in case of any financial crisis, issuing more shares and generating money from the market would not be an issue for the company. A further issue would benefit the creditors as they are now sure that the company is in a position to repay their money but on the other hand this would reduce the earnings of the existing shareholders.

X5 (Sales/Total Assets): This ratio is known as asset turnover ratio and is an indicator of how efficient the company is in using its assets and thus, generating income or sales.
Unreliable Books

The Z-score can be affected by situations where the books of the company are not maintained accurately or properly. Like for example, in the case of “WorldCom” the management of the company made a mistake and ended up recording few billions as capital expenditure when it had to actually figure under the heading of “operating expenses”.

Such an entry in the books would have two significant effects; it would result in overstating the assets of the company and also overstating the earnings. The X3 ratio would be affected by the overstated earnings whereas on the other hand the ratios like X1, X2 and X5 would be affected by overstated assets. These accounting problems will lead to a situation of lowering the Z-score of the company.

Testing the condition with WorldCom

The applying of the Z-score model on the WorldCom Company for the years 1999, 2000 and 2001 goes to show that the Z-score of WorldCom has been falling rapidly. This goes to show how the accounting abnormalities can adversely affect the Z-score.

A Test Using WorldCom

Significance

Edward Altman’s model is very different from the initial studies made, which were based all on a single ratio. His Z-score model that he developed is a comprehensive study that involves conclusions drawn on the basis of five ratios.

The five ratios study the various aspects of the company and are good indicators of the company’s financial condition and are thus, useful in predicting bankruptcy. At the time there were several doubts and queries regarding the effectiveness of the Z-score model in being able to predict bankruptcy.

There were several other models that were proposed by experts in the field like Fischer Black, Myron Scholes, Robert Merton and the like. Although there was several other models proposed yet the Z-score model proposed by Edward Altman continues to remain the best-tried and tested formula for ascertaining the credit worthiness of the company.