How confident are you of your business's financial health? More importantly, what is the data that you've used to arrive at this conclusion? If the answer to these questions is that you 'think' your business is in trouble because your gut tells you it is, then you're probably right.
A gut feeling however, may not tell you how much trouble your business is in, which is important. Measuring financial distress is helpful as the potential solutions available for companies in distress can change depending on the severity of the problems, and it is beneficial for all parties that problems are dealt with before the impact on creditors is made worse.
Instead, what you should be using is a tried and tested system that takes your firm's financial data, crunches the numbers and produces an accurate measure of corporate financial health. Better yet, the results should be presented in such a way that directors can easily compare their firms to others that have become insolvent. Fortunately, there's simple way to work out exactly where you stand. Enter, the Z Score.
Z Scores show how similar a company's situation is to other businesses who have faced formal insolvency procedures.
About the Z Score
In a nutshell, the Z Score is a quick and simple way of estimating the likelihood of financial distress at some point in a company's future. The system was developed by Edward I. Altman in 1968, while he was an Assistant Professor of Finance at New York University. At the time, Altman was looking for a way to easily distinguish between financially healthy businesses and others with more risk. He used data from 66 publicly held manufacturing brands - 33 of which had filed for insolvency - and came up with an intricate formula that would combine key financial ratios in order to arrive at a 'score.'
There can be a lot of variation between Z Scores, but in general the most important consideration is whether the number is greater or lower than three. If a company's Z Score is 2.99 or below, the chances of financial distress in the next two years are pretty high, while anything below 1.80 indicates that the company is already in significant financial distress.
It's not the most precise system in the world, but that's because Z Scores aren't actually supposed to reveal when or why a company is going to become insolvent. Instead, the Z Score simply shows how similar a company's situation is to other businesses who have filed for insolvency.
Accurately calculating your company's Z Score
A Z Score can provide you with an instant indication of how stable your company is, but how accurate are the results really? Well, in Altman's initial tests, the Z Score was discovered to be 72 per cent accurate in terms of predicting company bankruptcy (insolvency) two years early. By the year 2000, after some refinement, that number had risen to between 80 and 90 per cent.
If you're at all worried about your business, finding out its Z Score is an absolute necessity.
For an example of Z Scores at work, Business Insider points out the work of Morgan Stanley, strategy analyst Graham Secker, who used the system to rank various European companies, finding "that a company with an Altman Z Score of less than 1 tended to underperform the wider market by more than 4 per cent."
If you're at all worried about your business, finding out its Z Score is an absolute necessity, but surely that requires all sorts of complex spreadsheets and powerful computer software, right? Not at all! Calculating a Z Score is quick and easy when you use the McDonald Vague Z Score Calculator. All you'll need are a few key bits of financial information. These are:
- Total assets
- All current and long-term liabilities
- Retained earnings
- Earnings before interest and taxes (EBIT)
- Market value
- Net worth (total assets minus total liabilities)
- Sales
Of course, working out a Z Score is just the start of things. If the results aren't good, you'll need the right help to either turn your business around or provide alternatives. McDonald Vague can assist, so get in touch with our team to find out more.