July 2020
Beginner
208 pages
3h 7m
English
Content preview from Financial Statement Analysis
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Chapter 9Forecasting Bankruptcy
Learning objectives
- Identify the ratios to be used in both of Altman’s models for bankruptcy prediction.
- Recognize how a Z-score determines the likelihood of bankruptcy.
Introduction
The purpose of this section is to provide you with a way to forecast bankruptcy using five simple ratios to determine a Z-score for any firm. The ratios used to determine the Z-score are working capital to total assets, retained earnings to total assets, E.B.I.T. to total assets, the market value of the firm’s equity to the book value of its debt, and sales to total assets. The Z-score is a measure of overall financial health.
Altman’s bankruptcy prediction formula
Z = .012X1 + .014X2 + .033X3 + .006X4 + .999X5
X1 = working capital/total assets
X2 = retained earnings/total assets
X3 = earnings before interest and taxes/total assets
X4 = total equity/total debt
X5 = sales/total assets
Z = overall index
Altman’s suggested Z-score cutoff
| If Z is | This indicates |
| Less than 1.81 | A problem |
| Between 1.81 and 2.99 | Concern |
| Greater than 2.99 | No problem |
The Z-score was developed using a statistical procedure called discriminant analysis. This procedure allows the statistician to find variables that distinguish between groups. In this case the procedure found five ratios that distinguish between bankrupt and non-bankrupt companies. The coefficients in front of the X variables come from the statistical procedure.
Computational note
Variables X1 to X4 are to ...
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