Z-Score

Z-Score

A mathematical formula developed in the 1960s by NYU Professor Edward Altman that attempts to express the chances of a public company going bankrupt within a two- year time period. The number produced by the model is referred to as the company’s Z-score, which is a reasonably accurate predictor of future bankruptcy. The model is specified as:

Z = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where:

Z = Score

A = Working Capital / Total Assets

B = Retained Earnings/ Total Assets

C = Earnings before Interest & Tax/ Total Assets

D = Market Value of Equity/ Total Liabilities

E= Sales/ total Assets

The zeta model returns a single number, the z-score, to represent the likelihood of a company going bankrupt in the next two years. The lower the z-score, the more likely a company is to go bankrupt. A z-score lower than 1.8 indicates that bankruptcy is likely, while scores greater than 3.0 indicate bankruptcy is unlikely to occur in the next two years. Companies that have a z-score between 1.8 and 3.0 in the gray area, bankruptcy is not easily predicted one way or the other.

Vermeer,

Audited financial statements

FYI

On December 2, 2001, Enron, a $700 billion company, filed for bankruptcy. The bankruptcy filing came after the company announced it had overstated earnings by approximately $600MM. Later, the on-site-accountant was charged with shredding work documents related to the audit. This example makes it clear that relying solely on audited statements will not prevent or protect a bank from lending to a company that may have significant problems. The audit itself, as in the Enron case, does not prevent misrepresentation to either company management or potential business bankers. This and other factors make the accountant’s job complicated. Although regulatory authorities attempt to keep financial reporting to investors at a high standard, financial statements need to be technically interpreted.

Do you have a special financial analysis process?

Vermeer,

I agree, there are certain market intangibles that we have no control over.

What are the warning signs for a “scammer” like Madoff when the regulatory authorities fail?

My financial analysis process is geared towards” lending”.

The profitability and soundness of any bank depend on the quality of its loan portfolio. Funds are acquired (at a cost) via deposits and the “rented” to borrowers.  

When conducting a financial analysis, I usually follow a four-step systematic approach:

• Obtain financial information;
• Process, spread and common-size financial statements;
• Analyze and interpret information; and
• Complete tend, comparative and continuity analyses.

To evaluate credit risk, I attempt to identify the uncertainties a commercial borrower may face. I must confirm, for example, that a borrower’s financial strengths and weaknesses are balanced. If its strengths exceed its weaknesses by a margin sufficient to cover perceived uncertainties, the borrower represents an acceptable risk.

Strengths – Weaknesses > Uncertainties = Acceptable Risk

Exxon Mobil corp. (XOM) does not fall into my loan portfolio hahaha.  

Most of my loans are <$250M.