Predictability of Insolvency on the basis of Ratios

In this article we will discuss about the Predictability of Insolvency on the basis of Ratios.

Edward 1. Altman of U.S.A. has developed a model on the basis of which insolvency of a firm can be predicted— this has been developed on the basis of empirical research conducted by him.

In Altman’s view, the Z’ value of the firm under study should be computed on the basis of the following:

Z = .012 X₁ + .014X₂ + .033X₃ + .006X₄ + .999X₅

where

X₁ = Working capital/Total assets

X₂ = Retained earnings/Total assets

X₃ = Earnings before interest and taxes/Total assets

X₄ = Market value of equity/Book value of total debt

X₅ = Sales/Total assets.

If Z, or the overall index, comes to more than 2.99, there is no danger of insolvency of the concerned firm, firms having a Z value below 1.81 face imminent insolvency; those having Z between 1.81 and 2.99 are in the grey area—there is a danger of insolvency.

The relevance of the ratios mentioned above will be apparent after a little thought. The ratio of working capital to total assets will indicate the liquidity of the firm; if the ratio is very small, it will mean lack of liquid finds to enable the firm to carry on its day to day work.

Insolvent firms generally have a minus working capital and that poses great danger as any fresh cash coming in will be used to pay off pressing claims—it will not be available for operating purposes.

Retained earnings to total assets indicate the wisdom of the management in disposing of or rather retaining profits. Retained earnings are a cushion against losses—the danger is great if the cushion is weak—in insolvent firms the cushion is non-existent as, usually, there are accumulated losses.

Earnings before interests and taxes to total assets (a form or ROI) shows at what rate fresh cash is flowing into the firm. Solvent firms have a sizeable stream of fresh funds; insolvent firms lose cash steadily—for them the ratio is usually minus.

Market value of all the shares compared with the amount of total liabilities of the firm will indicate the extent to which the debt is covered. It shows to what extent asset values may decline and still leave the firm in a position to cover the debt. If the value of equity is Rs 1,00,000 and liabilities total Rs 2,00,000 the total assets will be Rs 3,00,000.

If asset values decline by more than 1/3, debt will cease to be fully covered and the firm will be entering insolvency.

Ratio of sales to total assets is important since it is sales that will produce profits—a persistent ratio will lead the firm towards insolvency sooner or later.

In addition to the ratios stated above, another figure that is important is the “Net Credit Interval” indicating the period in which fresh funds must be raised if the firm is to continue to operate.

It may be calculated as:

The figure will indicate the period in months for which the firm has sufficient funds before the expiry of which it must raise fresh funds. If the period is much short than the period of the operating cycle—commencement of the production process and receipt of cash against sale—there is great danger of the firm being caught short of cash.

Cash Loss:

The ratios mentioned above were all developed in the western countries and, therefore, they may not have automatic application in India. But they do point to one more important factor— cash. All ratios emphasize the continued availability of cash and, therefore, insolvency (or sickness) can be easily predicted if cash flows are drying up.

The Reserve Bank of India is of the opinion that a firm is sick if it has a cash loss in the previous year and in the current year and is expected to incur a cash loss in the next year also. In other words, cash losses continuing for three years means sickness.

Cash loss, of course, means loss before depreciation and other write-offs. It means that the current cash costs exceed revenues. Cash loss for a firm is like loss of blood for an individual—both must be stopped immediately as otherwise death may occur.

Illustration 1:

Zed Ltd. present the following summarised statements relating to 2011-2012: