Businesses have been declaring bankruptcy at an alarming rate over the past several years.
According to the American Bankruptcy Institute (ABI), the largest multi-disciplinary, non-partisan organization dedicated to research and education on bankruptcy, 60,837 companies declared bankruptcy in 2009, the largest number since 1993.
This represents a 209 percent increase over the 19,695 business bankruptcies declared in 2006. During the first quarter of this year, 14,607 businesses have declared bankruptcy, a pace that surpasses last year’s first quarter figure. With so many companies declaring bankruptcy, the odds are increasing that one of your customers, suppliers or service providers may be next.
Bankruptcy is a “legally declared inability or impairment of ability of an individual or organization to pay its creditors.” The bankruptcy code provides for different types of bankruptcy depending on whether it’s an individual, business or municipality declaring bankruptcy and depending on the intended outcome of the process. The intended outcome falls into two categories: liquidation and reorganization.
In liquidation, the debtor’s assets (except for some protected assets in certain cases) are sold and the proceeds from the sale are distributed to the creditors in a specific order as provided by law. It confirms that there is no realistic hope for the debtor to clean up their act and pay what they owe. It’s about dividing whatever is left in the fairest way possible to the people who are owed money.
In reorganization there exists a realistic hope that, given some leeway in fulfilling its obligations, the debtor can pay what it owes over time and keep operating. Instead of being forced to liquidate, the debtor keeps their assets and works out a plan to pay most or all of what they owe over an extended period of time.
Bankruptcy by Type
The different types of bankruptcy that fall under these two outcomes are commonly referred to by the chapter of the bankruptcy code where they are presented:
- Chapter 7 bankruptcy is a liquidation bankruptcy for individuals and companies.
- Chapter 9 bankruptcy is a reorganization bankruptcy reserved for municipalities.
- Chapter 11 bankruptcy is a reorganization bankruptcy usually reserved for corporations and partnerships. In some cases individuals can also seek protection under Chapter 11.
- Chapter 12 bankruptcy is a reorganization bankruptcy reserved for family farmers and family fishermen.
- Chapter 13 bankruptcy is a reorganization bankruptcy reserved for individuals with a regular income.
- Chapter 15 deals with international or cross-border insolvency.
Bankruptcy Signals: Reading the Writing on the Wall
If a customer, supplier or service provider declares bankruptcy, the impact on your business can be significant. In some cases, it could lead to the closure of your business if it’s an exclusive supplier or your best customer. There are, however, several ways to help determine the likelihood that a company may go bankrupt. One method stands out among the rest.
The Altman Z-score for Predicting Bankruptcy
The Z-score formula developed in 1968 by Edward Altman determines the probability that a company will go bankrupt within two years. It remains the most-used and most-respected method for predicting bankruptcy. The formula was originally designed for public manufacturing companies with at least $1 million in assets but versions for non-manufacturing and private companies have been developed. Multiple tests have been conducted in the 40 years since the formula was developed to determine its efficacy.
Recent follow up tests show that the formula is 80 percent to 90 percent accurate at predicting bankruptcy within one year.
Ingredients for an Altman Z-score
The Z-score is basically a mathematical formula that takes the weighted sum of five key business ratios. The five ratios that are used to calculate the Altman Z-score are:
- T1 = Working Capital / Total Assets
- T2 = Retained Earnings / Total Assets
- T3 = Earnings Before Interest and Taxes / Total Assets
- T4 = Market Value of Equity / Book Value of Total Liabilities
- T5 = Sales / Total Assets
These five ratios are each multiplied by a coefficient before being added together to arrive at the Z-score.
The standard formula is:
Z = (1.2*T1) + (1.4*T2) + (3.3*T3) + (0.6*T4) + (.999*T5)
Interpreting the Z-score Results
After preforming the calculations above, the end result will be a number that you will then compare to the established Z-score classifications:
- a Z-score greater than 2.99 puts the company in the safe zone which means bankruptcy is unlikely within the next two years
- a Z-score between 1.80 and 2.99 puts the company in the grey zone which means it could go either way in the next two years
- a Z-score below 1.80 puts the company in the “distress zone” which means bankruptcy is likely within the next two years
Some Things to Keep in Mind When Using the Z-score
The Altman Z-scored does not work for financial companies. So if you are selling to banks, this isn’t an appropriate tool. Also remember that the formula is modified if you are evaluating private companies and non-manufacturing companies. If you would like an Excel model of the Altman Z-score (including variations for private and non-manufacturing companies) just send me an email.
Mike Periu is the founder of EcoFin Media, LLC an independent producer of financial, economic and entrepreneurial content for television, radio, print and the internet. Over the past ten years he has started three companies and advised over 50 companies on financial strategies including fundraising. Mike also hosts regular small business webinars on a range of topics relevant to business owners.