What is the Financial Health of Your Business?

What is the financial health of your company?

Knowing the financial condition of your business is extremely important. Fortunately, there is an easy, efficient and reliable way to monitor the fiscal health of your company.

It’s called the Z Score.

The Z Score was developed in 1968 by NYU Professor Edward Altman.  Professor Altman originally intended the Z Score to be a predictor of a Company’s inclination for bankruptcy.

The Z Score for privately held companies consists of 5 performance ratios that are combined into a single score.  The five ratios are weighted using the following formula:

Z  Score = .717A +.847B + 3.107C + .420D + .998E

 

Where:

A = Working Capital/Total Assets

B = Retained Earnings/Total Assets

C = Operating Income/Total Assets

D = Book Value of Equity/Total Liabilities

E = Sales/Total Assets

When analyzing the Z Score, the lower the value, the higher the likelihood of bankruptcy.  The following parameters can help in assessing your company’s position:

Below 1.2 indicates a firm headed for bankruptcy

Between 1.2 and 2.9 is a “gray area”

Above 2.9 indicates bankruptcy is unlikely

Caution: While the above parameters are helpful, my experience has been that individual Companies tend to gravitate toward their own  Z Score and changes can be subtle.  Be very mindful of the trend and take action when the trend goes down.

The importance of analyzing the Z Score trend is highlighted in the case of Borders  Bookstores.  Borders Z Score for the 5 years immediately preceding their bankruptcy follow:

Year                                                                    Z Score

2006                                                                       2.81

2007                                                                       2.00

2008                                                                       1.96

2009                                                                       1.86

2010                                                                       1.79

 

Borders went into bankruptcy in 2011 and the steady decline in their Z Score should have been a warning sign.

Every business owner should know their company’s Z score.  It’s easy to compute and  when monitored over time can be an insightful tool in assessing financial risk.

At Stevenson Valuation Group it’s standard practice to compute the Z Score for all client companies.  We’ve developed a template to facilitate the computation and would be happy to share it with you.

It’s FREE, just send us an e-mail.

Sincerely,

Thomas G Stevenson, CPA, CVA

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