APPLICATION OF RATIO ANALYSIS

The Z-score formula for predicting bankruptcy was published in 1968 by Edward I. Altman,
who was, at the time, an Assistant Professor of Finance at New York University. The formula
may be used to predict the probability that a firm will go into bankruptcy within two years. Z-
scores are used to predict corporate defaults and an easy-to-calculate control measure for the
financial distress status of companies in academic studies. The Z-score uses multiple corporate
income and balance sheet values to measure the financial health of a company.

The formula
The Z-score is a linear combination of four or five common business ratios, weighted by
coefficients. The coefficients were estimated by identifying a set of firms which had declared
bankruptcy and then collecting a matched sample of firms which had survived, with matching by
industry and approximate size (assets).

Altman applied the statistical method of discriminant analysis to a dataset of publicly held
manufacturers. The estimation was originally based on data from publicly held manufacturers,
but has since been re-estimated based on other datasets for private manufacturing, non-
manufacturing and service companies.

Original Z-score component definitions

X1 = working capital / total assets
X2 = retained earnings / total assets
X3 = earnings before interest and taxes / total assets
X4 = market value of equity / total liabilities
X5 = sales / total assets

Z-score bankruptcy model:

Z = 0.012X1 + 0.014X2 + 0.033X3 + 0.006X4 + 0.999X5

X1,X2,X3,X4 are in percentage points

Zones of discrimination:

Z > 2.99 – "safe" zone

1.81 < Z < 2.99 – "grey" zone
Z < 1.81 – "distress" zone

Z-score estimated for non-manufacturers and emerging

markets
 X1 = (current assets − current liabilities) / total assets
X2 = retained earnings / total assets
X3 = earnings before interest and taxes / total assets
X4 = book value of equity / total liabilities

Z-score bankruptcy model (non-manufacturers):

Z = 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4[6]

Z-score bankruptcy model (emerging markets):

Z = 3.25 + 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4

Zones of discrimination:

Z > 2.6 – "safe" zone

1.1 < Z < 2.6 – "grey" zone
Z < 1.1 – "distress" zone

Application Question

The final accounts of PQR Ltd for the years ending 31 December were as follows:

Balance sheet as at 31 Dec. 17 31 Dec. 18

Sh.000 Sh.000
Fixed assets at cost 35,200 47,800
Depreciation (19,000) (21,500)
16,200 26,300
Current assets
Stock (inventory) 10,000 30,000
Trade Debtors 17,200 53,400
Bank 1,800 _
29,000 83,400
Current liabilities
Trade Creditors 13,600 22,000
Bank overdraft - 31,600
Taxation 6,400 10,400
Proposed dividends 6,000 12,000
 26,000 76,000

Total assets less current liabilities 19,200 33,700

Long term creditors:
15% debentures (1,200) (1,500)
Net assets 18,000 32,200

Financed by:
Ordinary share capital of Kshs.1 (par) 10,000 10,000
10% preference shares of Kshs.1 (par) 2,000 2,000
Profit and loss account 6,000 20,200
18,000 32,200

Income statement for year ended 31 Dec. 17 31 Dec. 18

Sh.000 sh.000
Sales (credit) 330,000 410,000
Cost of sales (250,000) (310,000)
Gross profit 80,000 100,000
Total expenses (38,720) (45,000)
Profits before interest and tax 41,280 55,000
Interest paid (560) (1000)
Interest received 80 200
Profit on ordinary activities before tax 40,800 54,200
Tax on ordinary activities 10,400 15000
Profit for the financial year 30,400 39,200
Dividends expense 16,200 20,000
Retained profit for the year 14,200 19,200

Required:
Compute Altman’s Z score and interpret the score i.e whether the company is in safe, grey or
distressed zone 20 marks)