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How to Predict Bankruptcy

The Altman Z-score has been found of considerable accuracy in predicting bankruptcy, which can come in handy for Indian investors


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This old article may have references to outdated tax rules and laws. For up-to-date information on taxation of mutual funds, refer to https://www.valueresearchonline.com/tax/

The Z-score formula was developed by Edward Altman, Assistant Professor of Finance at New York University. The score predicts bankruptcy two years prior to its occurrence. The Z-score concept was first published in 1968. The score tries to predict the probability of default by companies due to financial distress. It is based on the current financial statistics of the company.

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The formula for the Z-score is:
Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + 1T5
Where:
T1 is working capital divided by total assets (measures liquid assets in relation to the size of the company).
T2 is retained earnings divided by total assets (measures profitability that reflects the company's age and earning power).
T3 is earnings before interest and taxes divided by total assets (measures operating efficiency apart from tax and leveraging factors. It recognises operating earnings as being important to long-term viability).
T4 is market value of equity divided by book value of total liabilities (adds market dimension that can show up security price fluctuation as a possible red flag).
T5 is sales divided by total assets (standard measure for total asset turnover).

When
Z > 2.99, the company is considered in the 'safe' zone.
1.81 < Z < 2.99, the company is considered in the 'grey' zone.
Z < 1.81, the company is considered in the 'distress' zone.

As per Altman's study, the average Z-score for the group of companies which got bankrupt was -0.25. For the non-bankrupt group, it was 4.48. His test was found to be 72 per cent accurate in predicting bankruptcy two years before the event and 80-90 per cent accurate one year before the event.

However, one drawback of the Z-score is that it only works on manufacturing companies and has been tested in the US market. We cannot follow it blindly or thoroughly test this ratio in India due to bankruptcy rules and attitudes towards bankruptcy in India. In India, companies rarely go liquid and hence we are left with very few examples.

Our take
We tested 298 manufacturing companies of the BSE 500 index, tweaking the formula a little, to check how they have fared over the last five years. For total assets, we considered only tangible assets and working capital without current investments. Five years ago the companies which were in the distress zone were 25 in number, but currently there are 74 companies which are in the distress zone. Also, the average three-year return (considering two years of predictability) of the companies which were in the distress zone five years ago is 16.51 per cent; of those in the grey zone, it is 23.77 per cent; and of the ones in the safe zone, 27.71 per cent.

Z- score statistics of BSE 500 companies

ZoneRangeAvg 3Y return (%)No. of companies
FY10      FY15
Distress zoneLess than 1.816.512473
Grey zone1.8 to 2.9923.777765
Safe zoneMore than 327.71197160

Manufacturing companies with lowest Z-scores in BSE 500 companies

Company nameSectorZ-score
HMTAutomobile & Ancillaries-12.9
Orchid Chemicals & PharmaHealthcare-0.2
GVK Power & InfrastructurePower0.18
Lanco InfratechInfrastructure0.2
ABG ShipyardShip building0.24
KSK Energy VenturesPower0.24
Shree Renuka SugarsAgri0.26
Jaiprakash AssociatesConstruction materials0.27
GMR InfrastructureInfrastructure0.29
Jaiprakash Power VenturesPower0.3

We picked five companies which had defaulted on debt or bonds in the last couple of years and calculated their Z-scores two years before the default. Altman's Z-score clearly predicted the defaults in four out of five cases. In one case in which it did not predict a default exactly, it was very close indeed.

Here, the Z-score tells us that despite the market rejoicing at a level higher than what it was at five years ago, for manufacturing companies it's more distress time. The Z-score may not be completely compatible because the Indian equity market is an emerging market but it may come handy to have a second opinion while making investment decisions.

Distressed companies and their Z-scores two years ago

Company nameZ-scoreZone
Bhushan Steel0.77Distress
GTL Infrastructure-0.11Distress
Rei Agro1.72Distress
Deccan Chronicle Holdings2.29Grey
Kingfisher Airlines-1.29Distress

This old article may have references to outdated tax rules and laws. For up-to-date information on taxation of mutual funds, refer to https://www.valueresearchonline.com/tax/

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