Once again we see the alarm being sounded by an academic who just happens to be the creator of the infamous Z-score that is said to correlate well with the probability of bankruptcy.

According to Bloomberg …

“GM, Ford `On the Verge of Bankruptcy,' Altman Says (Update2)

“General Motors Corp. and Ford Motor Co., the two biggest U.S. automakers, have about a 46 percent chance of default within five years, according to Edward Altman, a finance professor at New York University's Stern School of Business.”

“‘Both are in very serious shape and the markets reflect that,’ Altman, the creator of the Z-score mathematical formula that measures bankruptcy risk, said in an interview with Bloomberg Television. The model shows that these companies are “on the verge of bankruptcy,'’ he said.”

What’s wrong with this picture?

First, the mathematical model does not directly measure bankruptcy risk, it attempts to model bankruptcy risk by using a number of common easily-computed business ratios that are then weighted to approximate the probability of bankruptcy.

Second, it is based upon circumstances existing at a single point in time when the analysis is performed.

And third, circumstances can easily change over all (short-, medium- and long-term) time frames which can alter both the model and the underlying reality.

Artificially creating havoc?

To simply say that a company has a predicted chance of a bankruptcy in the coming five years is, in my opinion, not helpful to the company or the public as it may set into motion a public reaction leading to a loss of capital, customers and other opportunities that might be normally available to the company. Thus creating a self-fulfilling prophesy of failure based on nothing more than the loss of consumer/customer/counterparty confidence. Similar to the catastrophe which befell Bear Stearns when both investor and counterparty confidence was eroded by, among other things, rumors in the marketplace.

What is the Z-score?

According to Wikipedia …

“The Z-score formula for predicting bankruptcy was developed in 1968 by Edward I. Altman, a financial economist and professor at the Leonard N. Stern School of Business at New York University. The Z-score is a multivariate formula that measures the financial health of a company and predicts the probability of bankruptcy within two years.”

“Studies measuring the effectiveness of the Z-score have shown the model to be accurate with >70% reliability (Eidleman).”

“The Z-score combines four or five common business ratios using a weighting system calculated by Altman to determine the likelihood of bankruptcy. The weighting system was originally based on data from publicly held manufacturers, but has since been modified for private manufacturing, non-manufacturing and service companies.”

“The original data sample consisted of 66 firms, half of which had filed for bankruptcy under Chapter 7. All businesses in the database were manufacturers, and small firms with assets of <$1million were eliminated.”

The original score was as follows: Z = 1.2T₁ + 1.4T₂ + 3.3T₃ + .6T₄ + .999T₅.

T₁ = Working Capital / Total Assets. Measures liquid assets in relation to the size of the company.

T₂ = Retained Earnings / Total Assets. Measures profitability that reflects the company's age and earning power.

T₃ = Earnings Before Interest and Taxes / Total Assets. Measures operating efficiency apart from tax and leveraging factors. It recognizes operating earnings as being important to long-term viability.

T₄ = Market Value of Equity / Book Value of Total Liabilities. Adds market dimension that can show up security price fluctuation as a possible red flag.

T₅ = Sales/ Total Assets. Standard measure for turnover (varies greatly from industry to industry).

Variations on a theme …

It should be noted that there are a number of variations in the basic scoring system and the weighting averages which are subject to change over time. Many professionals tweak this algorithm to compensate for private companies as well as introduce other values such as those predictive of sector performance. The more complicated the formula, the greater the probability of systemic errors and the less likelihood of maintaining statistical validity to a high level of confidence.

What does it really mean?

The Z-Score is simply a tool as is other formulas or a comparative ratio analysis using data from the Internal Revenue Service or from Robert Morris and Associates (now called the Risk Management Association)

It should be noted that, like most mathematical models, one can derive a numerical value by plugging in the appropriate information… but the output value must be correctly interpreted by professionals with some knowledge of the underlying economic and company values. Merely changing the accounting methods when revenue is booked or costs expensed or capitalized can have far reaching effects on the ratios which, in turn, greatly affect the derived result.

Bottom line: while this score may be used by financial types as a rough guideline to the likelihood of insolvency, the score itself must be interpreted in conjunction with other company factors and analysis of the sector grouping and the economy.

A moving target …

Considering that the economy, cost of borrowed funds, discontinuance of business lines, revaluing the inventory and any number of events may occur, this Z-score analysis must be re-computed time and time again. And, in many cases, the rate of change may be more significant that the score itself. As an example, Bloomberg also reports that

“In 2005, Altman said GM had a 47 percent chance of default within five years.”

“The Z-scores for GM and Ford give both a bond rating equivalent to a CCC ranking, though GM is in slightly worse condition than Ford, Altman said. GM reported a $38.7 billion loss in 2007, the biggest in its 100-year history, and hasn't posted a profit since 2004. The scores are based on the companies' finances at the end of the first quarter.”

Ability to Refinance

“‘The thing that triggers a default in almost all cases is running out of cash and not being able to refinance,’ Altman said in an interview prior to his television appearance. ‘You're not going to go bankrupt as long as you can refinance short-term liabilities. You will go bankrupt if you can't.'’'

What can YOU do?

Be extremely careful when chasing rumors or so-called professional advice from someone whose hidden agenda may simply be self-serving media attention.

Be even more careful of those Wall Street Wizards who thrive on conflict and volatility – they make money only when people buy and sell, nothing when they continue to hold their positions. The old Wall Street saying “Churn ‘em and burn ‘em” has never been truer. Especially when we can see Wizards earning their multi-million dollar bonuses while their customers fight to stay above water.

As with any computational model, be it a computerized financial or global warming model, the results must be tempered with common sense and an awareness of the environment which gives rise to much of the impact on the subject being modeled.

Become aware of the “halo” effect which describes someone who may have reached the pinnacle of their profession or earned an inordinate amount of money. The confluence of events which gave rise to their success may rarely or never duplicated again. Perhaps the reason for so few second stellar acts from high-performing individuals. In many cases, their notoriety, success and wealth will pre-position them for access to additional capital and the very best deals. Something that a lesser mortal may never experience.

-- steve

Quote of the Day: “Imagination is everything. It is the preview of life's coming attractions.” -- Albert Einstein

A reminder from OneCitizenSpeaking.com: a large improvement can result from a small change…

The object in life is not to be on the side of the majority, but to escape finding oneself in the ranks of the insane. -- Marcus Aurelius

Reference Links:

GM, Ford `On the Verge of Bankruptcy,' Altman Says (Update2)|Bloomberg.com