# Financial Distress Prediction Using Altman Z-Score and Cash Flow Ratios ## Step 1: Collect and Prepare Data Assume the firm's summarized accounting data for the last 5 years as below: | Year | Working Capital | Total Assets | Retained Earnings | EBIT | Market Value of Equity | Book Value of Debt | Sales | Cash Flow from Ops | |------|----------------|--------------|-------------------|------|-----------------------|--------------------|-------|--------------------| | 1 | 100 | 100 | 200 | 120 | 300 | 400 | 900 | 110 | | 2 | 90 | 980 | 190 | 110 | 280 | 420 | 870 | 100 | | 3 | 75 | 950 | 170 | 90 | 240 | 450 | 820 | 80 | | 4 | 50 | 910 | 140 | 60 | 200 | 500 | 750 | 50 | | 5 | 20 | 870 | 100 | 30 | 150 | 550 | 700 | 20 | ## Step 2: Compute Altman Z-Score for Each Year **Altman Z-Score (for manufacturing firms):** \[ Z = 1.2X_1 + 1.4X_2 + 3.3X_3 + .6X_4 + 1.X_5 \] Where: - \(X_1 = \frac{\text{Working Capital}}{\text{Total Assets}}\) - \(X_2 = \frac{\text{Retained Earnings}}{\text{Total Assets}}\) - \(X_3 = \frac{\text{EBIT}}{\text{Total Assets}}\) - \(X_4 = \frac{\text{Market Value of Equity}}{\text{Book Value of Debt}}\) - \(X_5 = \frac{\text{Sales}}{\text{Total Assets}}\) **Calculate for each year:** ### Year 1: - \(X_1 = 100/100 = .10\) - \(X_2 = 200/100 = .20\) - \(X_3 = 120/100 = .12\) - \(X_4 = 300/400 = .75\) - \(X_5 = 900/100 = .90\) \[ Z_1 = 1.2(.10) + 1.4(.20) + 3.3(.12) + .6(.75) + 1.(.90) = .12 + .28 + .396 + .45 + .90 = 2.146 \] ### Year 2: - \(X_1 = 90/980 \approx .092\) - \(X_2 = 190/980 \approx .194\) - \(X_3 = 110/980 \approx .112\) - \(X_4 = 280/420 \approx .667\) - \(X_5 = 870/980 \approx .888\) \[ Z_2 = 1.2(.092) + 1.4(.194) + 3.3(.112) + .6(.667) + 1.(.888) \\ = .110 + .272 + .370 + .400 + .888 = 2.040 \] ### Year 3: - \(X_1 = 75/950 \approx .079\) - \(X_2 = 170/950 \approx .179\) - \(X_3 = 90/950 \approx .095\) - \(X_4 = 240/450 \approx .533\) - \(X_5 = 820/950 \approx .863\) \[ Z_3 = 1.2(.079) + 1.4(.179) + 3.3(.095) + .6(.533) + 1.(.863) \\ = .095 + .251 + .314 + .320 + .863 = 1.843 \] ### Year 4: - \(X_1 = 50/910 \approx .055\) - \(X_2 = 140/910 \approx .154\) - \(X_3 = 60/910 \approx .066\) - \(X_4 = 200/500 = .40\) - \(X_5 = 750/910 \approx .824\) \[ Z_4 = 1.2(.055) + 1.4(.154) + 3.3(.066) + .6(.40) + 1.(.824) \\ = .066 + .216 + .218 + .240 + .824 = 1.564 \] ### Year 5: - \(X_1 = 20/870 \approx .023\) - \(X_2 = 100/870 \approx .115\) - \(X_3 = 30/870 \approx .034\) - \(X_4 = 150/550 \approx .273\) - \(X_5 = 700/870 \approx .805\) \[ Z_5 = 1.2(.023) + 1.4(.115) + 3.3(.034) + .6(.273) + 1.(.805) \\ = .028 + .161 + .112 + .164 + .805 = 1.270 \] **Summary Table:** | Year | Z-Score | |------|---------| | 1 | 2.15 | | 2 | 2.04 | | 3 | 1.84 | | 4 | 1.56 | | 5 | 1.27 | ## Step 3: Calculate Cash Flow Ratios ### 1. Operating Cash Flow to Total Debt \[ \text{OCF to Debt} = \frac{\text{Cash Flow from Ops}}{\text{Book Value of Debt}} \] ### 2. Operating Cash Flow to Total Assets \[ \text{OCF to Assets} = \frac{\text{Cash Flow from Ops}}{\text{Total Assets}} \] | Year | OCF to Debt | OCF to Assets | |------|-------------|--------------| | 1 | 110/400 = .275 | 110/100 = .11 | | 2 | 100/420 ≈ .238 | 100/980 ≈ .102 | | 3 | 80/450 ≈ .178 | 80/950 ≈ .084 | | 4 | 50/500 = .10 | 50/910 ≈ .055 | | 5 | 20/550 ≈ .036 | 20/870 ≈ .023 | ## Step 4: Draw a Financial Distress Radar Chart **Key ratios for radar chart:** - Z-Score - OCF to Assets - OCF to Debt **Sample radar chart data (for Year 1 and Year 5):** | Metric | Year 1 | Year 5 | |---------------|--------|--------| | Z-Score | 2.15 | 1.27 | | OCF/Assets | .11 | .023 | | OCF/Debt | .275 | .036 | *Radar chart visual would show severe contraction in all dimensions by Year 5.*  *Alt text: Radar chart comparing Z-Score, OCF/Assets, and OCF/Debt for Year 1 and Year 5, showing declining values in all metrics.* ## Step 5: Comparative Trend Analysis (5 Years) - **Profitability:** EBIT, margins, and retained earnings consistently declined. - **Liquidity:** Working capital and OCF fell sharply. - **Leverage:** Book value of debt increased while equity and asset base declined. - **Z-Score:** Dropped below 1.8 (distress zone) by Year 4, signaling high bankruptcy risk. - **Cash Flow Coverage:** OCF to debt fell from a healthy .275 to a critical .036, indicating inability to service debt from operations. ## Step 6: Conclusion – Technical or Economic Insolvency? - **Technical Insolvency:** The firm cannot meet short-term obligations as OCF and working capital are severely strained (OCF/Debt and OCF/Assets at critical lows). - **Economic Insolvency:** Sustained losses (declining EBIT and retained earnings), Z-Score in the distress zone, and negative trend in OCF suggest the firm's assets are insufficient to cover liabilities if liquidated. **Final Judgment:** **The firm is facing both technical and economic insolvency.** It is unable to meet its short-term commitments and is at high risk of bankruptcy, as indicated by Altman Z-Score and cash flow ratios. --- ### References - Altman, E. I. (1968). Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy. - Standard financial statement analysis literature. --- *Note: For a real-world case, use the firm's actual financial statements.*