Edward Altman published the Z score formula for predicting bankruptcy way back in 1968. He said this formula can be judiciously used to find whether any company may go into bankruptcy within the next two years. It is a quick find formula to gauge the financial health for publicly held companies by using the P&L values and Balance sheet values through a mix of business ratios.
In simple terms Z =1.2X1+1.4X2+3.3X3+0.6X4+1.0X5, where
X1= Working capital/Total assets.i.e the ratio of liquid assets in relation to the total assets or size of the Co.
X2=Retained earnings/Total assets i.e the ratio of retained profit in relation to the total assets of the Co.
X3=EBIT/Total Assets i.e the ratio of efficiency of the operations without the impact of leveraging, in relation to the assets deployed in the Co.also signifying the importance of operating earnings for the long term financial health of the Co.
X4=market capitalisation/book value of total liabilities i.e the ratio of market price in relation to the total liabilities incl. borrowings are considered as a reflection financial health;
X5= Total sales/ Total assets i.e the ratio of assets turnover indicating how well the assets are utilised to generate the sales.
There are some variations for privately held companies and for service cos.
What is the necessity for delving into this formula of bankruptcy now? RBI appointed KV Kamath Committee has come out with similar ratios for the use of banks in identifying distress among the Indian business companies with various ratio values depending on the kind of business the cos concerned are in.
The Committee came out with the following ratios, that were selected based on their relevance for Resolution Plan for the distressed cos. when their loans are put to restructuring by the banks.
1)Total outside liabilities(TOL)/Adjusted Tangible Networth(ATNW)i.e Adjusted Net of investments;
2)Total Debt/EBIDTA ;
3)Current Ratio;
4)Debt Service Coverage Ratio (DSCR);i.e the ratio of the addition of the net cash accruals with interest and finance charges divided by the addition of the current portion of the long-term debt with interest and finance charges.
5) Average Debt Service Coverage Ratio (ADSCR) i.e average over the loan period.
All these ratios are highly relevant with a well-defined threshold for various industries of the domestic economy including that of services, for those looking at the financial health of the Companies. Many Credit Rating Agencies also use many of these ratios. Perhaps, the Altman Z score may also be included for evaluating the preponderance to bankruptcy among the Co.s under the distressed category seeking their bank loans to be restructured.
