|
|
 |
|
|
|
|
|
|
 |
|
 |
|
|
| Predicting financial recovery |
|
- Dale Pudney |
24 February 2005 |
 |
|
WHEN a company is on a path of decline, business owners and managers are often in denial or ignorant of the fact that their company is about to hit that brick wall known as the burning platform — a pivotal point with very little chance of return.
Depending on the severity of the state of decline, a turnaround strategy should be implemented to revert the business back to a healthy financial state.
Unfortunately, the signs of decline are often not apparent as it may be masked by positive ratios on the financial statements and by the fact that the business is still making a profit. This lulls the business owner into a false sense of security.
It is this state of complacency or denial that is particularly dangerous. Chances of a successful turnaround are almost zero if left too late. When is it too late?
The likelihood of recovery is not good when the company is threatened with foreclosure or liquidation.
The Z-score — a globally acknowledged financial predictor of bankruptcy developed by a New York financial economist and professor Edward Altman — has been in existence for more than 30 years. It is a mathematical calculation that works on analysing various ratios of the company’s finances to its financial health.
These factors include working capital; how much cash the company has to survive; retained earnings; total assets; earnings before interest and tax; the market value of equity (the book value of equity in a private company); sales; and the book value of total liabilities.
A more effective method to predict bankruptcy, the Z-score is able to forecast the probability of bankruptcy within 12 months.
The formula is calculated on six factors. Z is the overall index of corporate health, x1 is the working capital divided by total assets, x2 is the retained earnings divided by total assets, x3 is net profit before interest and taxes divided by total assets, x4 is the market value of preferred and common equity divided by total liabilities (in private organisations the book value of preferred and common equity is substituted), and x5 is the sales divided by total assets.
The calculation of Z is as follows: Z > 1,2 (multiplied by) x1 + 1,4 x2 + 3,3 x3 + 0,6 x4 + 1,0 x5. This produces a Z-score ranging from –5 to +10.
The combination of these financial areas coupled with the Z-score calculations, predicts whether a company is in decline — with different calculations for manufacturing and non-manufacturing sectors.
Within a manufacturing environment a score of 1,875 and below indicates a likelihood of insolvency within 12 months.
Within a non-manufacturing environment a score of 1,10 and below is similarly damning.
The next range of scores is a high-risk zone, indicating that managers should take steps to improve business performance, as bankruptcy is imminent.
A turnaround strategy can make use of the Z-score as a foundation to identify techniques that improve the performance of a business. This is especially relevant when considered in conjunction with a comprehensive diagnostic of the business model, where weak areas can be identified and a strategy formulated to initiate improvements.
A common mistake is to only restructure debt and finances in an effort to deliver the company back from the brink of insolvency.
This is however a short-term solution. According to research conducted in the US, between one quarter and one third of all distressed firms re-enter financial distress within a few years after completing a debt restructuring.
A turnaround strategy must look at the entire business model (the income statement aspect of the financials) and not just the balance sheet, which can be manipulated to become misleading.
A proactive approach through the Z-score’s predictive outcome with prudent “checks and balances” and continuous business model analysis and optimisation, is the preferred choice, because the likelihood of returning a company to profitability once stranded on the burning platform is extremely difficult.
Pudney is director at Turnaround Partners. |
|
|
|
|
|
|
|
|
 |
|
 |
|
|
|
|