Your Z-Score

Every business generates a stream of information that can be managed and interpreted. One of the main purposes of gathering accurate information is so you can make better decisions. Good decisions produce results that will help you realize a desired outcome.

In other words, to improve your ability to achieve your goals, you must gather accurate information that will answer questions such as: Will I be able to make payroll? Do I have enough working capital? Am I using my assets wisely? How profitable is my business?

Financial ratios provide a report card to evaluate your progress and determine the critical areas you should focus your efforts on. Ratios are basically numbers formed by comparing one or more components of your business with each other to express a relationship. The ratio then must be compared to a standard (past, future, or industry ratios).

Using ratios to operate your business could be compared to using a compass to guide a boat because it helps determine your direction in relationship to the standard of true north. If you wisely use the instruments to navigate a boat, you will eventually reach your destination. Use ratio analysis to help make better decisions and you will eventually reach your goals.

There are numerous ratios that are used to determine liquidity (the ability to meet short-term obligations), leverage (measuring solvency or debt to equity), activity (how your resources are used), and profitability. However, there is no single ratio that can alert you to looming financial problems; there is one formula, though, that will give you a good indication if your company is healthy or headed toward Chapter 11. In 1968 Dr. Edward Altman, a financial economist and professor at New York University Stern School of Business, developed the Z-Score analysis that combines five different financial ratios to determine the likelihood of bankruptcy. Given the high delinquency rate in the CNMI, the Z-Score should be very useful to existing business owners, lenders, and investors.

The five ratios used to calculate your Z-score include: 1) return on total assets, 2) sales to total assets, 3) equity to debt, 4) working capital to total assets, and 5) retained earnings to total assets. The results from these ratios are multiplied by a predetermined weight factor and then added together and the results will fall between –4 and +8. Healthy companies will have a Z-score above 3.0, while those below 1.8 may be headed toward bankruptcy. A score in between those rages indicate your company is in a grey area that could go either way.

Generally, the higher the score the more financially sound your company. In Altman’s initial study of 33 bankrupt companies, the Z-scores was accurate for 95 percent of the companies indicated trouble or imminent bankruptcy.

Here is the Z-score formula: Z = 1.2 (working capital/total assets) + 1.4 (retained earnings/total assets) + 3.3 (earnings before interest & tax /total assets) + 0.6 (market value of equity/total liabilities) + 1.0 (sales/total assets).

Your Z-score is not perfect because it will need to be calculated and interpreted with care. False accounting practices—such as the shenanigans at Enron and WorldCom—can artificially improve your standing. To get an accurate assessment of your current situation, you must gather accurate data.

Also, if your business is new with little or no earnings, the Z-score won’t be useful because the score will be low, but your company growth may be attractive. Scores will change from quarter to quarter if your company records one-time write-offs. This will change the final score and indicate your company is on the verge of bankruptcy, when in reality it is okay. Also, the Z-score does not address cash flow issues directly, so even though your score is high, you still may not be able to pay the bills.

In summary, take into consideration other elements when you calculate your Z-score and use it as an important measure of your company’s situation. Just like a doctor will look at various elements, such as your blood pressure, temperature, and heart rate to determine your health, your Z-score provides an overall indication by comparing five different ratios. It is probably better used as a gauge of relative financial health rather than as a predictor.

Using the Z-score can signal problems ahead and provide you with a simpler conclusion than trying to plow through the mass of ratios to come up with an answer. If your score indicates a problem, take heed and make some course corrections that can keep you from being delinquent in your obligations.

(Rik is a business instructor at NMC and Janel is the owner of Positively Outrageous Results. They can be contacted at: biz_results@yahoo.com)