The “Z” Factor
Often many business owners wonder if there is a way they can judge their solvency. In other words, is there a simple way of pointing to one number and determining whether the warning signs of bankruptcy are on the horizon, and whether a change of a course of action is required.
There is. Here is an excerpt from the director of the National Tax Institute, Inc. that explains how this concept is applied.
The Altman Z Score has become generally accepted as a ratio that is highly correlated with bankruptcy. It works on companies within most traditional industries such as retailers, wholesalers and manufacturers. For highly leveraged industries, however, the Score may be distorted.
The Altman Z Score is computed by combining four significant performance ratios that are from totals on the profit and loss and balance sheet of a company. These ratios are: (1) Working Capital divided by Total Assets, (2) Retained Earnings divided by Total Assets, (3) Net Earnings Before Interest and Income Taxes divided by Total Assets, and (4) Net Worth divided by Total Debt.
If the result of adding these four ratios is 1.00 or less then this is an indication that the company is headed toward bankruptcy. If the ratio is 1.00 to 2.50 then problems are likely. If the ratio is 2.50 or greater then the company is strong and has an unlikely risk of bankruptcy. Anything between 5.00 and 9.00 is considered to be a sign of solvency and strength.
The next time someone asks you what your Z Factor is be sure you know it!
