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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Building Value is a Process–Part Three

Under the Income Approach to valuation, maximizing value becomes a function of increasing net cash flow , decreasing an investor’s perception of risk or a combination of both.  Last month we discussed various ways to increase net flow and this month we’ll review various ways to reduce investor’s risk.  In valuation terms, investor’s risk is also referred to as an investor’s required rate of return or, capitalization rate, and it is expressed as a percentage.

A key component in determining the value of a going concern is the strength and transferability of the business’ cash flow.  An investor is likely to pay more for a cash flow that’s predictable than one that is subject to various internal and/or external sources of risk. 

The general rule of thumb is “the lower the risk the higher the value.” 

Below is a sample of some of the factors we commonly consider when evaluating the strength and transferability of cash flow.       

·         Company operating history and volatility of cash flow

·         Depth and quality of management

·         Competition and barriers to entry

·         Access to capital resources

·         Reliance on key person(s)

·         Size and geographic diversification

·         Concentration in customer base

·         Market resources in light of competition

·         Purchasing power and other economies of scale

·         Product and market development resources

·         Technological obsolescence

·         Reliance on vendors

·         Distribution system

·         Financial reporting and controls

·         Long term contracts with customers or unique products or

            market niche

·         Patents, copyrights, franchise rights, proprietary products

·         Operating facilities and capital investment needs

·         Industry and economic conditions

Broadly speaking, capitalization rates range from 17% at the low risk end of the spectrum to over 30% at the high end of the spectrum.  

By working with management, Stevenson Valuation Group has, over time, assisted management in increasing value by enhancing the quality of the company’s cash flow.