Not surprisingly, 2009 was a record year for bankruptcy filings in the U.S. According to the American Bankruptcy Institute, the number of businesses filing for bankruptcy here in Washington state increased from 477 in 2007 to 714 in 2008 and then to 1,158 in 2009.
The Z-Score
Fortunately, there is a time-tested tool that has proven itself useful in predicting bankruptcy called the “Z-Score”. Developed by Edward Altman way back in 1968, the original formula was based on a sample of 66 publicly traded manufacturing firms with assets greater than $1 million. In 2002 Altman updated his research for private companies and made adjustments for non-manufacturing companies. I should point out that in this era of proprietary research and down loadable fee-based calculators, the nice thing about this model is that it is both free and reliable.
Z Math
The Z-Score model requires knowing only five factors about a company: working capital (WC), total assets (TA), net worth (NW), total debt (TD), and operating income (OI). Once these are determined the following formula is used to determine the Z-Score for private non-manufacturing companies: 6.56*(WC/TA) +1.05*(NW/TD) + 3.26*(NW/TA) + 6.72*(OI/TA). To interpret the result, the lower the resulting score, the higher the probability of bankruptcy. A score below 1.81 indicates insolvency while a score of 2.65 or lower indicates the possibility of bankruptcy.
Benchmarking
Given the continued economic uncertainty, this tool can be useful to provide a benchmark for the financial viability of a company and can be monitored over time to determine if the company is increasing or decreasing its risk of failure. No matter what your role – be it shareholder, manager, board member, or potential investor - the Z-Score is a useful tool that can quickly provide a measure of a company’s risk of insolvency.
As a CFO Consultant I often deal with the Z score. Thanks for breaking it down so plainly; it's a great indicator of predicting bankruptcy.
Posted by: CFO Consultant | March 29, 2011 at 02:58 PM