Financial management revision question & answer

The Altman formula for prediction of bankruptcy is given as follows: Z score = 1.2X1 + 1.4X2 + 3.3X3 + 1X4 + 0.6X5
Where: X1 = Working capital/Total assets
X2 = Retained earnings/Total assets
X3 = Earnings before interest and tax/Total assets
X4 = Sales/Total assets
X5 = Market value of Equity/Liabilities

In this model, a Z-score of 2.7 or more indicates non-failure and a Z-score of 1.8 or less indicates failure.
You are provided with the following information in respect of four listed companies.


Required:
a) The Z-Score for each of the companies. Comment on the results obtained.
b) It has been suggested that other ratios ought to be incorporated into Altman‟s
bankruptcy prediction model. What is your opinion on this?
c) List the indicators of possible business failure.

ANSWER


All firms are at the blink of bankruptcy since their Z-score is less than 1.8. Company C has the lowest Z-score and company A the highest Z-score.

b) Other important ratios to include are:
i) Current ratio
ii) Acid test ratio
iii) Interest cover ratio
iv) Debt ratio

Ratios (i) and (ii) will indicate liquidity which ratio (iv) is vital for measuring gearing.

c) Indicators of possible business failure are:
– Declining time interest earned ratio (interest cover)
– Huge contingent liabilities
– Low liquidity ratios and negative net working capital
– Increasing reliance on leasing rather than purchase of tangible assets
– Cash flow statement indicates declining cash balances

– Low z-score values as shown Altman model.
– High labour turnover and declining profits.

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