How Does Ed Predict My Business is Going to Go Bankrupt? And Who is Ed?

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We are quite sure that many business owners and financial managers, and to some degree even sophisticated financial analysts have never heard of Edward Altman.

Altman was a pioneer in financial research into troubled firms. He was a New York professor/scholar. Obviously this took a lot of what we could call ' back testing ' - that is to say going back in a companies history to determine why they failed and what were the financial characteristics of that failure.

A lot of his work revolves around the in depth analysis of 33 firms that went bankrupt eventually.

Altman wrote volumes on companies in distress and bankrupt companies, and is most known for his contribution of a short formula called 'THE Z-SCORE '.

What is the Z-SCORE? In essence it's a predictor of bankruptcy and business failure! One might think the formula is overly complex, but it is not. It is simply an analytical tool that could be used by any business owner, financial manager, or for that matter a personal investor looking to purchase a stock in the stock market. It is somewhat of a dramatic statement, but Altman felt you could predict the bankruptcy, in many cases, several years before the actual event. (Short sellers of stock take note!!)

Altman developed the tool in the 1960's and we feel it is still very valid today. The ultimate result of a Z-SCORE calculation is an absolute number. If firms have a score of 1.8 or less Altman maintains the company is a strong credit for bankruptcy.

How is the score calculated? Again, readers will be surprised at how easy the score is to calculate. Remember that the absolute number of the score essentially is a reading on the company's financial health.

The elements of the score are as follows:


Working Capital
Total Assets
Retained Earnings
Earnings/Profit
Sales
Total liabilities

Note ** If any business owner does not know how to get those numbers from his financial statement we suggest they are already headed for business failure!

The calculation is done as follows:

Working Capital divided by Total Assets
Retained Earnings divided by total assets
Earnings divided by total assets
Retained Earnings divided by Total liabilities
Sales divided by Total Assets

Each number is calculated and then added up. The result is a final Z-SCORE. Remember that we have said that if a company has a score of less than 1.8 Altman believed they were headed for bankruptcy. (Note there is a weighting assigned to each calculation also - readers can do their own research on the calculation) Obviously when he back tested those financials of firms that ultimately failed he showed they had exhibited a score of less than 1.8 much earlier.

Altman noted that firms with a Z-SCORE of greater than 3 were, in general, strong financially. Readers can also guess that a company with a score somewhere in the middle is a firm in the 'grey zone '. The bottom line - lower is worse!

So would you invest your personal money in the stock market in a company that had a Z-SCORE of 1.8? And do you believe you have a tool that can effectively predict the ultimate failure of a company. And finally, do you know the Z-SCORE of your own firm as a business owner or financial manager - we have shown that it is not hard to calculate. We note that ALTMAN did feel strongly that the formula works better for larger corporations. What the reader does with that data is a subject of another discussion.

No formula is absolute, but, the weight of evidence suggests that if Ed (his formula /model) is predicting something, we should listen!



Stan Prokop is the founder of 7 Park Avenue Financial

http://www.7parkavenuefinancial.com

The company originates business financing for Canadian companies and is a specialist in working capital and asset based financing of all types. For more information or contact details please see: http://www.7parkavenuefinancial.com

7 Park Avenue Financial
South Sheridan Executive Centre
2910 South Sheridan Way
Suite 301
Oakville, Ontario
L6J 7J8



Direct Line = 416 319 5769

Office = 905 829 2653


Email = sprokop@7parkavenuefinancial.com

' Canadian Business Financing with the intelligent use of experience '


ABOUT THE AUTHOR
Stan has had a successful career with some of the world’s largest and most successful corporations.
Prior to founding 7 Park Avenue Financial in 2004 his employers over the last 25 years were, ASHLAND OIL, ( 1977-1980) DIGITAL EQUIPMENT CORPORATION, ( 1980-1990) ) CABLE & WIRELESS PLC,( 1991 -1993) ) AND HEWLETT PACKARD ( 1994-2004 ) He is an expert in Canadian Business Financing.

Stan has over 40 years of business and finance executive experience. He has been recognized as a credit/financial executive for three of the largest technology companies in the world; Hewlett-Packard, Digital Equipment and Cable & Wireless. Stan has had in depth, hands on experience in assessing and evaluating thousands of companies that are seeking financing and expansion. He has been instrumental in helping many companies progress through every phase of financing, mergers & acquisitions, sales and marketing and human resources. Stan has worked with startups and public corporations and has many times established the financial wherewithal of organizations before approving millions of dollars of financing facilities and instruments on behalf of his employers.


Stan Prokop



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