Formula to Predict the Future

Edward Altman, a professor of finance at New York University's Stern School of Business, developed the Altman Z in 1968 to measure the financial health of a company and forecast the probability that a company would enter into bankruptcy within a two-year period.

Studies measuring the effectiveness of the Z Score show that the model has over a 70% reliability factor. With a 40-year history and 70% plus reliability, this seems to be a Z that is dependable.

Although originally developed for public firms, Altman devised a version for private companies, such as dealerships.

The Z Score formula is:

Z = 6.56 (X1) + 3.26 (X2) + 6.72 (X3) + 1.05 (X4).

Here is a condensed version of Altman's definitions of the four variables from his July, 2000 paper entitled “Predicting Financial Distress of Companies: Revisiting the Z-Score and Zeta® Models.”

X1, Working Capital/Total Assets (WC/TA).

The working capital/total assets ratio, frequently found in studies of corporate problems, is a measure of the net liquid assets of the firm relative to the total capitalization.

Working capital is defined as the difference between current assets and current liabilities. Liquidity and size characteristics are explicitly considered. Ordinarily, a firm experiencing consistent operating losses will have shrinking current assets in relation to total assets. Of the three liquidity ratios evaluated, this one proved to be the most valuable.

X2, Retained Earnings/Total Assets (RE/TA).

Retained Earnings is the account which reports the total amount of reinvested earnings and/or losses of a firm over its entire life. The retained earnings account is subject to “manipulation” via corporate quasi-reorganizations and stock dividend declarations. While these occurrences are not evident in this study, it is conceivable that a bias would be created by a substantial reorganization or stock dividend and appropriate readjustments should be made to the accounts.

The age of a firm is implicitly considered in this ratio. For example, a relatively young firm will probably show a low RE/TA ratio because it has not had time to build up its cumulative profits. Therefore, it may be argued that the young firm is somewhat discriminated against in this analysis, and its chance of being classified as bankrupt is relatively higher than that of another older firm, ceteris paribus. But, this is precisely the situation in the real world…

In addition, the RE/TA ratio measures the leverage of a firm. Those firms with high RE, relative to TA, have financed their assets through retention of profits and have not utilized as much debt.

X3, Earnings Before Interest and Taxes/Total Assets (EBIT/TA).

This ratio is a measure of the true productivity of the firm's assets, independent of any tax or leverage factors. Since a firm's ultimate existence is based on the earning power of its assets, this ratio appears to be particularly appropriate for studies dealing with corporate failure. Furthermore, insolvency in a bankrupt sense occurs when the total liabilities exceed a fair valuation of the firm's assets with value determined by the earning power of the assets.

X4, Net Worth/Book Value of Total Liabilities (MVE/TL).

Altman substituted net worth (excess of assets over liabilities) for the market value in order to derive a discriminate function for privately held firms (Z')… and for non-manufacturers (Z”).

As a general rule a Z Score of 1.10 or lower indicates that bankruptcy is likely, while a score of 2.60 or above can be an indicator that bankruptcy is not likely. A score between the two is the gray area. Keep in mind that these are general ranges and not specific to auto dealerships.

So what “Z” mark did your store leave? Is it getting better or worse over the months and years?

Don Ray is a CPA and has over thirty years experience in working with car dealers. He may be reached at 917-359-5128 and [email protected]