Z-Score Bankruptcy Model Introduction

If you own a heating and air conditioning company, you need to know about the Z-Score Bankruptcy Model.

This famous and widely used model (or ratio) represents the important work of New York University’ Professor Edward I. Altman. Originally, Altman studied 33 public corporations that filed for bankruptcy and 33 control firms selected at random. Using a very sophisticated statistical technique referred to as multiple discriminate analyses (MDA), he discovered that bankruptcy could be predicted up to two full years in advance through ratio analysis.

HVAC managers using this formula should keep in mind that Altman excluded corporations with assets less than one million dollars. Also, decision making based on the Z-Score factors is biased towards short term credit risk avoidance, and may not be appropriate for companies needing to develop new products, services, or markets. Please note different industries may operate under conditions that make the Z-Score factor (the actual score) less clear. Depending on the industry, some organizations can operate effectively with low Z-Score factors that may otherwise cause problems for other industry groups. Managers need to consider this when evaluating their Z-Score performance.

Z-Score Model Limitations

HVAC Financial managers need to realize that there are important limitations to this financial model. As you will learn, net profit before taxes (NPBT) is one of the most important of all factors. If management or officers do not pay themselves annual compensation that is considered “typical” or “normal”, net profit may be over or understated. This will adversely affect your Z-Score analysis, as it does not consider NPBT. Generally speaking, owners or an air conditioning and heating company (HVAC) should be paid approximately 6% to 8% of sales. If management does not track inventory properly or does not perform bookkeeping functions properly and accurately, the Z-Score may be completely useless.

Management is cautioned of these limitations and strongly encouraged to carefully study the formula and consider what other factors may be improperly stated and therefore affect the Z-Score.

The Actual Z-Score Formula *

Z = (0.717* X1) + (0.847* X2) + (3.107* X3) + (0.42* X4) + (0.998* X5)

Where

X1 = Working Capital /Total Assets

X2 = Retained Earnings / Total Assets

X3 = NPBT /Total Assets

X4 = Total Equity /Total Liabilities

X5 = Sales /Total Assets

Z = Overall index

 

G  The original Z-Score classifications are as follows:  < 1.23 suggests bankruptcy, > 2.90 suggests good financial health, and 1.23 to 2.90 is a gray area where bankruptcy cannot be predicted accurately.

Z-Score > = 5.0

A Z-Score >= 5.0 suggests that the company is in excellent financial condition and possibly over-capitalized. This company should have more than adequate cash, and other current assets, to meet its current obligations over the next twelve months. Bankruptcy or insolvency during the next two years is highly unlikely, unless conditions worsen rapidly and significantly. An analysis of efficiency and profitability ratios, such as Return on Assets, should be made in order to verify that the company is not overfunded. It may be possible that the company is not utilizing its current assets in the most efficient way.

Z-Score > = 4.50

A Z-Score >= 4.50 suggests that the company is in very good financial condition and well capitalized. This company should have sufficient cash, and other current assets, to meet its current obligations over the next twelve to twenty-four months. Bankruptcy or insolvency for the next two years is unlikely, unless conditions worsen rapidly and significantly.

Z-Score > = 4.00

A Z-Score >= 4.00 suggests that the company is in good financial condition. This company should have sufficient cash, and other current assets, to meet its current obligations over the next twelve months. Bankruptcy or insolvency during the next two years is unlikely, unless conditions worsen rapidly and significantly.

Z-Score > = 3.50

A Z-Score >= 3.50 suggests that the company is in moderately good financial condition. Bankruptcy or insolvency during the next two years is not particularly likely, unless conditions worsen rapidly and significantly. Careful and regular attention should be paid to this company’ financial matters and immediate action taken if financial indicators worsen.

Z-Score 1.81 to 2.99

A Z-Score of 1.81 to 2.99 falls within the “ignorance zone” of the Z-Score model and the data is inconclusive. However, it may suggest that the company’ financial condition is not strong and may be unstable. Bankruptcy or insolvency during the next two years cannot be accurately predicted.

Further analysis is required. A careful study of all financial reports, data, and ratios should be made by qualified personnel and, if required, corrective action taken immediately.

Z-Score > = 1.7

CORRECTIVE ACTION REQUIRED. A Z-Score >= 1.7 suggests that the company’ financial condition is weak and its future is in danger. The company is severely undercapitalized and needs additional current assets. Bankruptcy or insolvency during the next two years is very possible if corrective action is not taken immediately. Qualified personnel should make a careful study of relevant financial reports, data, and ratios.

Z-Score < 1.7

INSOLVENCY WARNING: A Z-Score < 1.7 suggests that the company’ financial condition is very weak and its future is in grave danger. The company is severely undercapitalized and needs additional current assets. Bankruptcy or insolvency during the next two years is highly likely if corrective action is not taken immediately. Qualified personnel should make a careful study of relevant financial reports, data, and ratios. A “turn-around” plan should be produced and implemented as soon as possible.

* Source: Corporate Bankruptcy in America, Edward I. Altman, John Wiley and Sons, Inc. No claim of copyright is made or asserted to his work.