Measuring a Company’s Risk of Bankruptcy

/in /by

By Mark T. Jude

In the world of finance there are many different types of risk and even more ways that attempt to measure or estimate that risk.  There are a numerous models and methods to estimate the risk of a company’s equity or debt, which are important in determining value.  But what about estimating a company’s risk of bankruptcy?

When Shenehon Company values a business, it calculates the business’s Altman Z-Score, which looks at a company’s risk of bankruptcy.  The Altman Z-Score model measures a company’s probability of bankruptcy within two years using financial ratios.  Instead of looking at financial ratios independently, this model uses multiple ratios to get a complete view of the company as a whole.  Ratios in the model look at liquidity, profitability, leverage and operational activity.  Each ratio on its own reveals important information and may highlight points of risk for the company, but the Z-Score measures the overall risk of the company.

This model was created in 1968 by Edward Altman, who is still a Professor of Finance in the Stern School of Business at New York University. The original model was created for public companies and Altman later created two additional Z-Score models: one for private manufacturing companies and another for private non-manufacturing companies.  For private business valuation we look at the latter two models.

Z-Score Model for Private Manufacturing Companies

The model for private manufacturing companies consists of five weighted factors:

  1. Working Capital to Total Assets Ratio
  2. Retained Earnings to Total Assets Ratio
  3. EBIT (earnings before interest and tax) to Total Assets Ratio
  4. Book Value of Equity to Book Value of Total Liabilities Ratio
  5. Sales to Total Assets Ratio

Factor 1 measures the liquidity (current assets minus current liabilities) of the company compared to its assets, in this case net current assets as a percentage of the total asset base.  Factor 2 measures the financial leverage of the company, with the difference between the two metrics implying debt or other liabilities.  Factor 3 measures the profitability of the company relative to its assets.  Factor 4 is another measure of the company’s financial leverage, looking at total capital.  Factor 5 measures the company’s ability to generate sales with its current level of assets.  After the ratios are calculated they are entered into the Z-Score formula shown below:

Z-Score = 0.717(F1)+0.847(F2)+3.107(F3)+0.42(F4)+0.998(F5)

To interpret the Z-Score one must compare it to three scoring ranges.  A score above 2.9 indicates that bankruptcy is not likely.  A score between 2.9 and 1.23 is known as the “grey” zone where bankruptcy may occur but is not imminent.  A score below 1.23 indicates the company is distressed and is likely to file for bankruptcy within two years.

Z-Score Model for Private Non-Manufacturing Companies

The model for private non-manufacturing companies is altered slightly.  This model omits Factor 5 and has different weighting and scoring ranges.  The model for private non-manufacturing companies is shown below:

Z-Score = 6.56(F1)+3.26(F2)+6.72(F3)+1.05(F4)

For this model a score above 2.6 indicates that bankruptcy is unlikely and a score under 1.1 indicates that bankruptcy is likely, while a score between 2.6 and 1.1 is the “grey” zone and is not a clear indicator.  According to Predicting Financial Distress of Companies: Revisiting the Z-Score and ZETA Models by Professor Altman, multiple tests performed from 1968 to 1999 have demonstrated that “the accuracy of the Z-Score model on samples of distressed firms has been in the vicinity of 80-90%, based on data from one financial reporting period prior to bankruptcy.”  The model predicted that a company would be bankrupt within the next two years and was incorrect on 15% to 20% of the time in these studies.

This model can point to weak areas in a company’s financials and show where efforts of improvement would make the largest impact, thereby minimizing the probability of bankruptcy.  For manufacturing companies or asset-intensive companies, it is common that the sales to total asset ratio has the largest impact on the Z-Score.  The model for non-manufacturing companies does not have a clear key factor and will vary on a case by case basis.

Z-Score Advantages

An advantage of the Z-Score Model is that all of the inputs are readily available on financial statements, making it simple to gather the required inputs.  There is no regression, calibration or complex statistical model needed to implement this model.  There are no assumptions made and the model does not rely on market data.  Another benefit is that the model is easy to interpret.  The score falls into one of the three categories, likely of bankruptcy, not likely of bankruptcy or in the “grey” zone of no indication.  Overall, this model is a good way for an investor, credit analyst, auditor, appraiser or business owner to estimate the company’s risk of bankruptcy.

The Complexity of Valuation Standards: Making Sense of the Acronyms

/in /by

By Joseph M. Mau

The various business valuation societies rely on different valuation standards. What are they and how do they impact you?

  • The American Society of Appraisers Business Valuation (ASA) business valuation standards are to be used with the Uniform Standards of Professional Appraisal Practice (USPAP), developed by the Appraisal Foundation.
  • The American Institute of CPAs (AICPA) valuation standards are the Statement on Standards for Valuation Services (SSVS).
  • The International Society of Business Appraisers (ISBA) valuation standards are three sections of USPAP (Standard 3: Appraisal Review, Development and Reporting, Standard 9: Business Appraisal, Development, and Standard 10: Business Appraisal, Reporting).
  • The Institute of Business Appraisers (IBA) has developed its own valuation standards.
  • The National Association of Certified Valuators and Analysts (NACVA) has developed its own standards.

Although some of these societies have identified their own valuation standards, the one standard that is relied on above all else is USPAP.  USPAP is the only standard mentioned by the IRS in its definitions of qualified appraiser and qualified appraisal and is the standard followed in Shenehon Company valuations. That does not discredit the other standards as they are still able to meet IRS requirements for a qualified appraisal; they just are not mentioned by the IRS.

The biggest difference between all of the organizations listed above is the difference in their engagements and reporting.  There are two different types of engagements: valuation engagements and calculation engagements.  Through these engagements there are different reports that can be prepared.  For a valuation engagement, there is the appraisal also known as a detailed report, which is a comprehensive report that provides sufficient information to permit intended users to understand the data, reasoning, and analyses of the valuation analyst’s conclusion of value.  Additionally there is a restricted appraisal (USPAP and ISBA) also known as a limited appraisal or summary report. A restricted appraisal is structured to provide an abridged version of the information that would be provided in a full appraisal, and therefore, it does not require the same level of detail as a full appraisal.

For a calculation engagement, there is a calculation report.  A calculation report is in some regards similar to a summary report but the valuation analyst and client agree in advance on the approaches and methods that will be used as well as the extent of procedures that will be used to calculate the value of a business or interest, and the valuation analyst must follow that arrangement.  Calculation engagements are also required to include the following statement: “This Calculation Engagement did not include all the procedures required for a Conclusion of Value. Had a Conclusion of Value been determined, the results may have been different.”  This statement shows that a calculation engagement is not a conclusion of value and would not hold up in court.  Below is a chart of the all the organizations and the reports they perform.

Valuation reports

When it comes to the valuation societies, each society has preference on which engagements are used.  For USPAP and ISBA, only valuations are performed and calculation engagements are not used.  ASA does a calculation but does not have a full calculation report.  AICPA, IBA, and NACVA perform calculation engagements and valuation engagements.

Another key part of a valuation report is its ability to comply with IRS Revenue Ruling 59-60.  Revenue Ruling 59-60 is structured as a list of eight factors-to-consider in valuations, followed by a discussion of each factor.  USPAP is the best example of including Ruling 59-60 in its standards as USPAP Standard Rule 9-4 is almost verbatim to the IRS definition.  The eight factors from Revenue Ruling 59-60 appear in all of the organizations’ standards for a comprehensive or full report although not for a calculation or calculation report.

Some people believe that a valuation based on more than one standard is not valid. Actually that is not the case. Standards of the AICPA, ASA, IBA, NACVA, ISBA and the Appraisal Foundation’s USPAP are quite complimentary.  USPAP has more specific requirements than the other sets of standards but they are generally very similar.  Additionally, to try and remain consistent across the industry, some of the organizations have adopted a uniform set of definitions and terms that appear in their glossary/appendix; organizations following this practice are: AICPA, ASA, NACVA and IBA.

Valuation standards are a tricky concept to understand, but once you understand the basis of each engagement and report you can quickly identify which report you need.  If you are only doing retirement planning or just inquiring about how much your business might be worth, a full appraisal or detailed report is not needed, a restricted appraisal, limited appraisal, or summary report would be sufficient.  However, if you are performing estate planning or shareholder dissolution, a more thorough report such as an appraisal or detailed report would be required to hold up in court.