Cezary Kozłowski, Jacek Michalak

The use of an Altman’s ratio to assess the current activities of the company

Keywords: business risk, Z-Score Model.

Abstract

The issue of evaluating the current threats to a company’s activities has significant implications for its functioning. The paper presents such an evaluation performed for two construction companies using Z-Score Model developed by Altman. The analysis has proven that the level of Z-Score is the consequence of the following relationships: the higher share of current assets in the company’s total assets decreases the risk of losing liquidity; the higher the share of debt in total equity and the liabilities, the higher the risk of losing the solvency; higher productivity of assets increases the company’s chances of development; increase of real market value of a company reduces the risk of its bankruptcy.

Practical applications of Z-Score Model can be very broad. While using it, one must be aware of its certain limitations and deficiencies. Therefore , this analysis can be used only as an advisory tool and should be only a part of a complex and deep business analysis.

Introduction

High level of economic development achieved in many countries would not have been possible without the credit in the sphere of goods manufacturing, services and consumption. The credit makes it possible to increase the current production and investments without the need of prior raising own financial resources.

Extending credits is one of the most important areas of operations of the banks and constitutes one of the basic revenue sources for them. Due to credits, the bank earns revenues from commission and interests. The importance of the credit-giving activity is emphasized by the fact that the share of this item in assets of commercial banks is between 25% and 50%. This means that profits or losses on this activity have a decisive impact on bottom-line results of many banks and their financial standing.

Extending credits creates an opportunity and gives a chance, but by no means guarantees the benefits. The reason of this is the credit risk, a phenomenon present during each lending of money, both by a bank or by any individuals or corporations. The risk is that the borrower will not fulfil the obligations, will not repay the principal amount and interests in the amount and terms stipulated in the credit agreement.

The credit risk of a bank may result from many factors. Therefore, a comprehensive assessment of the borrower is a very important part of the credit granting procedure. The credit rating of the borrower determines accurate decision making in terms of credit granting (Pawlak 2001). When conducting this type of analysis it is necessary to take into account the indices indicating the possibility of a company’s bankruptcy, enabling early detection and diagnosing of unfavourable symptoms in daily operations of the company. The present paper deals with this issue.

Materials and methods

The most commonly used ratios for forecasting the threats to current company operations include: Altman’s Z score (Z-score model, Z-score bankruptcy predictor), Zeta Credit Risk, the Taffler’s index and the Beaver’s index. They enable to define the economic and financial condition of a company and to indicate with high degree of probability the potential threats to its further functioning (Peplak 2002).

Among the above-mentioned ratios, the most popular, and at the same time relatively the easiest in use, is Altman’s Z score. While developing it, Altman used the econometric model based on specially selected economic and financial parameters. On the basis of this, Altman estimated 22 ratios defining liquidity, profitability, financial leverage and solvency. From this group, he chose 5 ratios which turned to be the most useful for assessing the solvency of the company and constructed the following model:

Z = 1.2x1 + .,4x2 + 3.3x3 + 0.6x4 + 0.999x5

where:

x1 – quotient of working assets by total assets;

x2 – quotient of net profit by total assets;

x3 – quotient of gross profit plus depreciation (so called EBIT) by total assets;

x4 – quotient of market value by total liabilities;

x5 – quotient of net sales by total assets.

The ratios in the Altman model define:

§ ratio x1 – financial liquidity and assets structure;

§ ratio x2 – profitability of assets;

§ ratio x3 – profitability of a company using external financing sources in relation to the assets value;

§ ratio x4 – effect of financial leverage and the rate of indebtedness in relation to the market value of the company;

§ ratio x5 – assets turnover (assets productivity).

All data needed to calculate the ratios may be taken from basic financial statements prepared by companies keeping commercial books. Only calculation of company market value may prove somewhat difficult. For the sake of this analysis, it was calculated by a simplified revenue method – simple net profit capitalization (Piechota 1997). The assumed capitalization rate was 12%.

According to Altman, the interpretation of the Z ratio should be as follows:

§ Z ratio above 2.99 – minimum risk of bankruptcy;

§ Z ratio between 1.81 and 2.99 – indeterminable risk of bankruptcy;

§ Z ratio below 1.81 – high risk of bankruptcy within the next two years.

The boundary value dividing potential bankrupts and companies in good condition is the ratio value at the level of 2.675.

Practice has confirmed high usefulness of the Altman ratio for forecasting company bankruptcy. By means of Altman analysis, about 95% of the bankrupting companies were included in the bankruptcy group (the Z ratio below 1.81) in the first year and about 72% after two years of operation (Peplak 2002).

The analysis of irregularities in current operations of a company will be performed in two construction companies. The research covers the years 1998-2000.

The companies operate in north-western Poland. During the period of research, they employed from 50 to 80 people. They deal with construction industry, particularly concentrating on designing, construction, refurbishment, modernization and maintenance of buildings.

The orders are fulfilled directly on construction sites under supervision of highly qualified specialists, possessing special certificates necessary to perform work in construction industry.

The quality of work performed by the two companies was considered good and very good by the clients. This was proven, among others, by letters of reference written by the largest clients.

The companies performed work in accordance with detailed requirements of the clients, which were incorporated into the designs. Manufacture of products and performance of work were in accordance with binding standards (Polish Standards, Industry Branch Standard).

Majority of sales of the studied companies came from investment projects. Recently, in the area of operation of the two companies, a reduction has been noted in the amount of resources for the construction investment projects, mostly due to their low profitability.

Main clients for the products and services offered by the companies in the scope of designing, construction, repairs, and modernization of buildings were businesses, state administration agencies and state budget units.

The companies were selling their services via participating in the floated tenders for construction work or without regulatory restraints.

Considerable seasonality could be noticed in sales of goods and services. Majority of those (over 80%) were sold in summer and autumn. Spring months (March and April) and winter were characterized by significant sales reduction. This had a major impact on financial results of the companies.

The market, in which the companies operated, is the investor’s market. The most important factors influencing a choice of a supplier in a tender are: price for services, keeping the time schedule, good quality of performed services, flexibility of the supplier in relation to the investor’s design requirements, the terms of guarantee for performed services, and after-sales services.

Results and discussion

Financial statements are the main source of information for the economic and financial analysis. The sources enabling comprehensive assessment of financial effectiveness of a company include periodically prepared basic statements, such as balance sheet and profit and loss account. The company’s balance sheet, prepared according to the “cautious evaluation” principles, has high cognitive value. However, the proper assessment of the balance sheet amounts must be linked with the cash flow assessment in the profit and loss account.

Synthetic data and ratios defining financial effectiveness of both companies are included in Table 1.

The table indicates that the capital employed in the company A was steadily growing during the years of the research. In 1998, it was PLN 2.034 million, in 1999 – PLN 2.181 million (a 7% increase), and in 2000 – PLN 2.625 million (a 20% increase). It has to be emphasized that both, working and fixed assets were growing. The company was investing relatively a lot. The company B, however, after the increase of capital from PLN 2.055 million in 1998 to PLN 2.119 million in 1999 (a 3% increase), experienced its decrease by 20% to the level of PLN 1.704 million. The most significant decrease was noted in fixed assets – the financial situation deteriorating, the company not only stopped investing but was even selling fixed assets.

During the years of the research, the liabilities of company A were steadily growing. But this growth was much slower than the growth of own capital, which enabled the company improve progressively the structure of liabilities. In 2000, the share of external capital reached almost 25%. In company B, in the first two years of the period, the liabilities were on similar level. In 2000, they rose by 14% to reach PLN 0.472 million, which was almost 28% of the total equity and liabilities.

In the period, the net sales revenues in company A were growing dynamically. Particularly good was the year 2000, when the sales increased by more than 30%. Company B experienced extremely high sales increase (by 82%) in 1999. The sales level in the following year was similar.

Financial costs (interests) of both companies were on relatively low level. The use of loans to finance operations and investments was insignificant.

Next category presented in Table 1 is the gross profit, which in both companies, equalled the profit on economic activity (no extraordinary profits or losses). The company A was making rather high gross profit – the gross profitability of sales reaching the level of 8.5 – 10%, which is rather a high value. In case of company B, the positive financial result was noted only in 1999, the same year it had a considerable sales increase. In remaining years, the company made gross losses – the revenues from economic activity were smaller than costs.

The net profit made during the period by company A was steadily rising. In 2000, it doubled the value from 1998 and the net profitability of sales was 6.3%. Company B made net profit only once, in 1999. The net profitability of sales reached the 5.2% mark.

The market value of a company is the most probable price obtainable in the market (Kucharska-Stasiak, 1998). From among many known evaluation methods, the revenue method (fixed rent) was chosen. The market value of company A increased twofold during the period, whereas company B had negative value due to losses made in 1998 and 2000.

Given indices needed to calculate the Altman’s ratio (Z) were as follows:

1. ratio x1 – a measure of financial liquidity and assets structure – in this three-year period was steadily improving in both companies, but the improvement was more notable in company A than in company B.

2. ratio x2 – a measure of assets profitability – was positive in the entire period only for company A and was dynamically improving. In case of company B, only in 1999 its assets were used profitably. During remaining years, the assets did not generate profits.

3. ratio x3 – a measure of profitability of assets of a company using external financing sources – was on the same level (0,177) in 1998-1999 in company A; the ratio increased considerably in 2000. In company B, this ratio was positive only in 1999; in two remaining years it assumed negative values.

4. ratio x4 – defining indebtedness of a company in relation to its current (actual) market value – reached a relatively high level in company A. Total debt was less than a quarter of total market capitalization of the company. The situation in company B in 2000 was opposite – the liabilities were more than four times higher than its actual market value.

5. ratio x5 – a measure of assets productivity (ability to generate revenues – was gradually increasing in both companies. However, it must be emphasized that while in company A the ratio was increasing due to sales growth, in company B the increase (in the last year of the period) was a result of decrease of the assets value because the sales rose only by 3%.

The Altman’s ratio (Z) for company A in the period 1998-2000 was on relatively high level and was steadily increasing. It was more than two times higher than the boundary value, dividing the companies in good condition from potential insolvents. The risk of company’s going bankrupt is low. In case of company B, this ratio decreased from 6.038 in 1999 to 0.050 in 2000, which indicates an abrupt weakening of its position. The demand for its market offer was insufficient. The costs exceeded the revenues and this was a main reason for Altman ratio’s reaching such a low value, considerably below 1.81.

Conclusions

Practical application of Altman’s Z score may be very wide. It may be used by the management team for financial analysis of a company and for benchmarking with other companies in the same area of operations. Auditors may use it for assessment of chances of survival of companies in financial trouble. Banks may also successfully use it to check credit rating of potential and existing borrowers.

The analysis presented above and the calculation formula of Altman’s ratio indicate that its size is a consequence of the following relationships :

· higher share of current assets in a company’s total assets decreases the risk of losing the liquidity;

· the higher the share of debt in total equity and liabilities, the higher the risk of insolvency;

· higher productivity of assets gives a company a chance of development;

· increase of real market value of a company decreases a probability of its bankruptcy.

While using Z-Score Model, it is necessary to be aware of its certain deficiencies and limitations which are related to high fluctuation of detailed data used in calculations (mainly the company’s market value) and to the fact that a ratio value for a given year may be accidental. Therefore, the ratio should be calculated for the longest possible period (a few or a dozen or so years) and then it should serve as a basis for drawing conclusions. It is worth remembering that Z-Score Model may be used only as an advisory tool and should be only a part of a comprehensive and deep business analysis.

References

KUCHARSKA-STASIAK E., 1998, Leksykon rzeczoznawcy majątkowego. PFSRM Warszawa.

PAWLAK Z., 2001, Biznesplan. Poltext Warszawa.

PEPLAK T., 2002, Jak przewidzieć upadłość przedsiębiorstwa? Gazeta Rachunkowa nr 6.

PIECHOTA J., 1997, Wartość spółki i firmy jako uzupełnienie wyceny majątku, stanowiącego zabezpieczenie kredytu bankowego. Wycena przedsiębiorstw. WACETOB Warszawa.