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The Z Score as a Turnaround Tool

The Z score has been slowly gaining acceptance as a financial predictor tool. The model does have usefulness beyond predicting possible bankruptcy. The underlying five component formula when studied and understood can help lead to a plan of action. Following the action plan and underlying components can assist management in effectuating a positive turnaround.

The swing from using the Z score predictor model by the passive credit analyst, banker, and those in academia to operating management and turnaround professionals can happen overtly or just be part of the method used in a turnaround. The model uses total assets as one of the denominators in four out of the five formulas. A key to a successful turnaround is converting unproductive assets into cash that critical to reducing debt and priming the turnaround.

This article will focus on Altman’s five-factor model vs. the four and seven-factor model. The five-factor model has been used primarily in manufacturing settings. The four-factor model was developed for non-manufacturing situations and eliminates one of the factors from the five-factor model vs. using other factors.

Let’s take a look at a fictional company; Lisa’s Clothing. Lisa’s Clothing is TMA’s case study for one of their educational programs. The company grew rapidly through acquisition and internal expansion funded primarily by debt. A snapshot of its five-year operating results is as follows:

Before we look at the Z score lets take a quick look at some commonly used ratios.

One tool that analysts, management and turnaround professionals would use is the liquidation ratios. The company’s liquidity eroded substantially during the period under review. The huge build up in Fixed Assets and Inventory has caused substantial strain on the company.

Another critical tool is the working capital ratio. The mismanagement of the company resulted in a $16,000,000 swing in working capital.

 

The operating ratios reflect a continued decline in gross profit as management has failed to stock the stores with appropriate merchandise resulting in a 7% erosion in gross profit margin and a 17% erosion in profits.

 

The company suffered its first operating loss in three years in 1997. The company still had working capital and its current ratio was above 1 to 1. Revenue had grown by $30 million and the loss was only $500,000. The Z score on the other hand paints a different picture at the end of year three. The Z score had dropped into the danger zone of under 1.8 in a sharp sudden fashion.

A Z score of 1.6 is in the low gray area range for a privately owned business. A low gray area score indicates that the company can possibly be headed for bankruptcy.

To understand the Z score you need to understand the components, and the relevance of the changes to the components to the end result.

The Z score has five ratios that are given different weights. The Five Measurers are:

· X1 = working capital / total assets

· X2 = retained earnings / total assets

· X3 = EBIT / total assets

· X4 = market value of total equity / book value of total liabilities (public companies)

· X5 = sales / total assets

· Z = overall index

The individual indicators reflect on various aspects of the company’s finances.

X1 = Working Capital / Total Assets – This measures the net liquid assets of the firm in relation to its total capitalization. Working Capital is the difference between current assets and current liabilities.¹

Many firms headed for troubled waters will experience a decrease in working capital. Assets will have ballooned and funds will have been spent on non-essential operations. The denominator is total assets. To increase this ratio the firm should focus on reducing its total assets. If the firm looks to fixed assets and other underutilized assets for dispossession to generate cash the denominator will decrease and the working capital will increase from the conversion of long-term assets into current assets or decreased liabilities. Some of the long-term assets will have long-term debt attached. The sale of these long-term assets may not improve the working capital ratio but would decrease total debt and improve profitability by decreasing interest and depreciation costs. The responsible parties must focus on long-term assets that generate cash. (Selling off assets to reduce cash outflow and debt is part of a solution discussed later.)

X2 = Retained Earnings / Total Assets – Retained Earnings is the accumulations of earnings that have remained in the entity. It should be noted that retained earnings could be affected by quasi-reorganizations and stock dividend declarations. If such an event occurred consideration should be made to readjust retained earnings. A young firm will be impaired by this ratio and this should be kept in mind.

To increase retained earnings the company needs to generate profits. The profits can be generated either through operations or the profitable sell off of assets, divisions or forgiveness of debt.

X3 = EBIT / Total Assets – This ratio is an indicator of the firm’ productivity of the firm’s assets, abstracting from any tax and leverage factors. Since a firm’s long term existence is based upon the earning power of its assets.²

Separately from reducing assets in an operating turnaround it is usually paramount to decrease costs and become a low cost producer. As you reduce your costs and the entity starts to produce profits the company’s working capital should increase (if not spent on capital items or acquisitions), retained earnings will increase (assuming no dividends or unnecessary distributions), and as the business cycles evolve cash should start to accumulate.

X4 = Market Value of Equity / Book Value of Total Liabilities – The measure shows how much the firm’s assets can decline in value (measured by market value of equity plus debt) before the liabilities exceed the assets and the firm becomes insolvent.²

Note: For privately held firms use net worth / total debt. This value is going to be smaller and the overall Z score indicators are adjusted downward to reflect this lower number.

X5 = Sales / Total Assets – The capital-turnover ratio indicates the sales generating ability of the firm’s assets. It is one measure of management’s capacity in dealing with competitive conditions.²

In many operational turnarounds sales decrease not increase as weak customers and product lines are eliminated. This is a short-term situation. The assets need to be deployed in sales / profit initiatives for long-term growth. The assets need to be deployed in profit generating activities for the company to segue into the future.

The algebraic formula for the Z Score is as follows:

No model indicates the exact time of failure but the Z score has been shown to indicate failure up to two years before the failure occurs. It has also been found that the most serious changes in the ratios occur between the third and second years prior to bankruptcy.

Publicly owned company:

Scores between 1.81 and 2.99 were in the gray area. Scores less than 1.81 indicate that failure is a real possibility. The lower the score the greater the odds of failure.

Privately owned company

The lower range is lower to account for book value vs. market value. The range becomes 1.23 to 2.90.

The Z score should be looked at over time rather than at any one point in time. The trend is important.

In 1997 when Lisa’s Clothing took on all the debt to expand, its Z Score decreased from 3.83 to 1.61. While the operating statement reflects a small loss the Z Score indicated that the company had over expanded and action was needed. The situation took a turn for the worse as management failed to take corrective action.

Previous management of Lisa’s clothing had followed a strategy that lowered the Z score.

Ø Management had over leveraged the company and invested in fixed assets and inventory that had failed to provide adequate returns.

Ø Management had opened additional stores that had failed to provide adequate returns

Ø Management had allowed gross profit to deteriorate because of poor product mix and overzealous buying.

It would appear that management was focused on building the revenue line without adhering to sound business practices regarding profitability and the impact on the Balance Sheet.

Total assets are the denominator in four of the five calculations. The company has excess assets in two major areas.

First, the inventory has grown from a low of 146 days to 252 days supply on hand.

Second the company has expanded to 75 stores expending large sums on leasehold, inventory, and deposits.

The Z Score provides guidance on improving the company’s performance by decreasing total employed assets the company will improve ratio one, two, three, and five. Generating cash from long term assets and reducing the inventory to historical norms will increase working capital and impact formula number one and three via decreased interest and depreciation costs. Operational improvement cannot be defined by the Z Score, yet increasing inventory turns and elimination of loosing locations will improve operating performance and impact formula three (EBIT / Total Assets).

Using computer simulation models to depict what the effects of the turnaround strategy will have on the numbers and the Z Score is a great way to communicate the action plan to interested parties. Performing a series of what-if analysis on your plan will assist in determining what results are required from the asset sell-off to provide the company a chance of survival.

A few areas in Lisa’s Clothing financial structure that will provide opportunity for improvement are:

Ø Inventory reduction – what impact will a sell off at a loss have?

Ø Leases – can the leases be sold and if sold at a profit or a loss?

Ø Leasehold improvements – part of the sale of the lease – any value?

Management and the turnaround professional must ask what level of losses can Lisa’s sustain in its asset reduction plan to generate cash. The simulation model and resulting Z Score can assist in determining those levels.

In the Z score the factor that gets the most weight (3.3X) is EBIT / Total Assets (3.3 X X3). Surprise, returning the entity to profitability will have the biggest impact on the academic Z score and the short and long-term viability of the entity.

Using the Z score and the impact of changes on the Z score as a basis for determining what action should be taken is the cornerstone of this article. With Total Assets the denominator in four of the five factors Lisa’s Clothing action plan should include;

Ø closing loosing stores,

Ø reducing unnecessary General and Administrative costs,

Ø reduce inventory,

Ø reduce fixed assets via sell off of leaseholds and other unnecessary assets.

Ø and increasing the gross profit.

If you make the following assumptions:

The goals and objectives in Restructuring Lisa’s Clothing are:

Ø Percentage of Stores to be closed: 33%

Ø Percentage Decrease in Inventory 50%

Ø Initial Decrease in Volume 20%

Ø Decrease in Store Level Costs (total) 40%

Ø Loss on Inventory Sell-off 20%

Ø Loss on Fixed Asset Sell-off 33%

Ø Planned Reduction in Prepaid Items 60%

Ø Return Gross Profit to Historical norms

The implementation of these changes will

The plan reflects expense reductions in payroll back to historical norms as a percentage of sales and reductions in publicity and selling costs to more modest levels, corporate costs were reduced to more reasonable levels, depreciation and interest costs decreases reflect the action taken, and gross profit is slowing moving back to earlier norms.

The sell-off of the assets allowed the company to pay down debt, reduce assets, increase working capital and make other improvements to the company’s long-term viability.

These changes and execution of the action plan resulted in a Z Score as follows:

Lisa’s Clothing’s Z Score is still in the gray area at the end of the first year of rehabilitation, but the profitable operations in year two moved Lisa’s beyond the gray area.

Execution of the strategy is more difficult than the theory. Following a plan that improves the Z Score will validate the turnaround plan. Following a plan that improves the Z Score provides management with a tool they can understand, buy into, and follow.