The values of X1, X2, X3, X4 and X5 are .1, .2, .08, .2 and .3....

The values of X1, X2, X3, X4 and X5 are .1, .2, .08, .2 and .3. Explicate the meaning of those numbers for the Z score. What are the prospects of this firm? Discuss thoroughly.

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Expert Solution

Formula of Altman Z Score is;

Z-Score = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

Where:

X1 = working capital / total assets

X2 = retained earnings / total assets

X3 = earnings before interest and tax / total assets

X4 = market value of equity / total liabilities

X5 = sales / total assets

Value of X1 (which is Working Capital/ Total Assets) = 0.10 (It means that 90% of the assets are invested in fixed assets while 10% is only invested in liabilities and hence liquidity crunch could occur as large funds are stuck in long-term assets)

Value of X2 (which is Retained earnings / Total assets) = 0.20 (It means that 20% of the earnings are retained in respect to total assets while 80% is paid out, it means that expansion of the company would be difficult as capital expenditures are made from the plow back of profits)

Value of X3 (earnings before interest and tax / total assets) = 0.08 (It means that operating profits are yielding just 8% return to the total assets of the company and hence operating capacity and or production are under serious threat as company’s long-term assets are huge and it could only generate a meager return of 8%)

Value of X4 (which is the market value of equity / total liabilities) = 0.20 (It means that the market value of debt is around 80%, indicating a heavy leverage on to the company as the equity portions stand at 20%)

Value of X5 (which is sales / total assets) = 0.30 (It means that the sales of the firm are generating 30% return in consideration to the total assets of the firm. But costs and leverage extremely high for the organization).

Z-Score = 1.2*(0.1) + 1.4*0.20 + 3.3*0.08 + 0.6*0.20 + 1*0.30

Or, Z- Score = 1.084

If the Value of the Z-Score’s value is below 1.8 then it clearly indicates that the firm is on the verge of bankruptcy and the symptoms are pretty much there. Leverage is standing at 80% while the operating profit is standing at 8% of its total assets indicates high % chance of getting bankrupted in the days to come.

jeff jeffy answered 1 year ago

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