Question

Altman’s original Z-score bankruptcy model takes five key ratios into account:

a. working capital / total assets

b. retained earnings / total assets

c. earnings before interest and taxes / total assets

d. market value of equity / total liabilities

e. sales / total assets

Discuss the reasons why these ratios are linked to the probability of going into bankruptcy, and comment on their relative importance.

Answer 1

Altman’s original Z-score bankruptcy model takes following five key ratios into account to analyses the probability of the bankruptcy in any company. These ratios are-

• working capital / total assets
• retained earnings / total assets
• earnings before interest and taxes / total assets
• market value of equity / total liabilities
• sales / total assets

These ratios are linked to the probability of going into bankruptcy because it is generally found that if the companies have a Z-score above 3, they are financial sound and if companies have Z-score below 1.8, they have high probability of bankruptcy.

These ratios are important measure of bankruptcy as the aggregate sum of these ratios shows a clear picture of situation, not the single ratio.

• Working capital / total assets is a good indicator of a firm's ability to make use of what it has in the near future.
• Retained earnings / total assets ratio is an indicator of how in debt the company is and whether it has a history of profitability.
• Earnings before interest and taxes / total assets ratio is a measure of efficiency and it indicates that how the company generates its earnings from every dollar of assets it has.
• Market value of equity / total liabilities ratio is a measure of the market's confidence in the company.
• Sales / total assets ratio is asset turnover ratio which shows the efficiency of the company to generate the revenue by using its asset.