# Financial Distress Prediction Using Accounting Data This step-by-step solution covers: 1. **Altman Z-Score Calculation** 2. **Key Cash Flow Ratios** 3. **Financial Distress Radar Chart (Conceptual)** 4. **Comparative Trend Analysis (5 Years)** 5. **Conclusion: Technical vs Economic Insolvency** --- ## 1. Altman Z-Score Calculation The **Altman Z-Score** predicts bankruptcy risk using accounting ratios. For publicly traded (manufacturing) firms: \[ Z = 1.2X_1 + 1.4X_2 + 3.3X_3 + .6X_4 + 1.X_5 \] Where: - \(X_1 = \frac{\text{Working Capital}}{\text{Total Assets}}\) - \(X_2 = \frac{\text{Retained Earnings}}{\text{Total Assets}}\) - \(X_3 = \frac{\text{EBIT}}{\text{Total Assets}}\) - \(X_4 = \frac{\text{Market Value of Equity}}{\text{Book Value of Total Liabilities}}\) - \(X_5 = \frac{\text{Sales}}{\text{Total Assets}}\) **Interpretation:** - **Z > 2.99:** Safe - **1.81 < Z < 2.99:** Grey Zone (potential distress) - **Z < 1.81:** High bankruptcy risk **Sample Data for Last 5 Years (Illustrative)** | Year | WC/TA | RE/TA | EBIT/TA | MVE/TL | S/TA | Z-Score | |------|-------|-------|---------|--------|------|---------| | 2019 | .18 | .12 | .10 | .80 | 1.50 | 2.37 | | 202 | .14 | .10 | .08 | .70 | 1.40 | 2.00 | | 2021 | .10 | .08 | .06 | .55 | 1.25 | 1.62 | | 2022 | .07 | .06 | .04 | .42 | 1.10 | 1.25 | | 2023 | .04 | .04 | .02 | .30 | 1.00 | .96 | --- ## 2. Key Cash Flow Ratios ### a. **Operating Cash Flow to Total Debt** \[ \text{OCF to TD} = \frac{\text{Operating Cash Flow}}{\text{Total Debt}} \] - Healthy: > .2 - Distress: < .1 ### b. **Cash Interest Coverage** \[ \text{Cash Interest Coverage} = \frac{\text{OCF} + \text{Interest Paid}}{\text{Interest Paid}} \] - Healthy: > 2. ### c. **Free Cash Flow to Equity (FCFE) / Net Income** \[ \text{FCFE Ratio} = \frac{\text{FCFE}}{\text{Net Income}} \] **Sample Data (Illustrative):** | Year | OCF/TD | Cash Int Cov | FCFE/NI | |------|--------|--------------|---------| | 2019 | .17 | 2.4 | 1.05 | | 202 | .15 | 2.1 | .93 | | 2021 | .10 | 1.7 | .82 | | 2022 | .07 | 1.2 | .65 | | 2023 | .04 | .9 | .48 | --- ## 3. Financial Distress Radar Chart **Conceptual Radar Chart Axes:** - Z-Score - OCF/TD - Cash Interest Coverage - FCFE/NI - EBITDA Margin - Debt/Equity **Interpretation:** A radar chart would visually show all metrics shrinking year-on-year, indicating worsening financial health.  *Alt text: Radar chart illustrating five years of financial distress metrics trending inward, showing decline.* --- ## 4. Comparative Trend Analysis (5 Years) ### Observations - **Declining Margins:** EBIT/TA, EBITDA margin, and FCFE/NI are all falling. - **Rising Leverage:** Debt-to-equity and total debt have increased. - **Weakening Cash Flows:** OCF/TD and cash interest coverage dropping below safe levels. - **Z-Score Ratios:** Moved from "grey zone" to "distress" (<1.81). | Metric | 2019 | 202 | 2021 | 2022 | 2023 | Trend | |------------------|-------|-------|-------|-------|-------|--------------| | Z-Score | 2.37 | 2.00 | 1.62 | 1.25 | .96 | Worsening | | OCF/TD | .17 | .15 | .10 | .07 | .04 | Worsening | | Cash Int Cov | 2.4 | 2.1 | 1.7 | 1.2 | .9 | Worsening | | FCFE/NI | 1.05 | .93 | .82 | .65 | .48 | Worsening | | Debt/Equity | 1. | 1.2 | 1.4 | 1.7 | 2. | Increasing | | EBIT/TA | .10 | .08 | .06 | .04 | .02 | Decreasing | --- ## 5. Conclusion: Technical or Economic Insolvency? ### Definitions - **Technical Insolvency:** Inability to meet current obligations (liquidity crunch), but assets exceed liabilities. - **Economic Insolvency:** Liabilities exceed assets; negative equity. The firm is not viable. ### Assessment - **The firm's Z-score is below 1.81 for the past three years, indicating high bankruptcy risk.** - **Cash flow ratios are below healthy thresholds, suggesting inability to service debt.** - **Rising leverage and declining margins show ongoing operational problems.** **If the firm is still able to cover liabilities with assets but is struggling to pay debts as they come due, it is facing _technical insolvency_. If liabilities have overtaken assets (negative equity), it is _economically insolvent_.** ### Final Answer > **Based on the sharply declining Z-score, worsening cash flow ratios, and rising leverage, the firm is in financial distress. If the balance sheet still shows positive net assets, the firm is technically insolvent. If equity has turned negative, it is economically insolvent. Given the five-year trend, the firm is at high risk of progressing from technical to economic insolvency if conditions persist.** --- **Summary Table** | Year | Z-Score | OCF/TD | Cash Int Cov | FCFE/NI | Technical Insolvency | Economic Insolvency | |------|---------|--------|--------------|---------|----------------------|---------------------| | 2019 | 2.37 | .17 | 2.4 | 1.05 | No | No | | 202 | 2.00 | .15 | 2.1 | .93 | No | No | | 2021 | 1.62 | .10 | 1.7 | .82 | Approaching | No | | 2022 | 1.25 | .07 | 1.2 | .65 | Yes | Possible | | 2023 | .96 | .04 | .9 | .48 | Yes | At risk | --- ## References -man, E.I. (1968). Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy. - Financial statement analysis texts --- *Note: Replace sample data with actual firm data for a real case.*