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This simple formula could have predicted the distress at many bankrupt Indian firms

Vatsal Bhandari

A slew of unforeseen corporate failures in India has brought to the fore the need for a reliable bankruptcy indicator.

Multiple companies—Jet Airways, Videocon, and Reliance Communications, to name a few—have crumbled into insolvent pitcher plants, seemingly from positions of strength. Jet Airways, for instance, had a market share of 13.9% in November 2018, second only to IndiGo Airlines, before it went belly up earlier this year.

Further, the debt of companies such as travel major Cox & Kings and Dewan Housing Finance Limited (DHFL) had healthy long-term ratings, with very low-to-moderate risk of non-payment, before they ultimately defaulted.

In hindsight, it appears that their “financial strengths” were merely an accounting facade, and credit rating agencies have been caught napping.

There is a need, therefore, to evaluate companies on an academically proven parameter that is consistent across jurisdictions. One such time-tested early warning system for corporate distress is the Altman Z-Score.

History

Edward Altman, in 1968, introduced the Altman Z-Score as part of a scholarly article published in the Journal of Finance. Altman, currently professor emeritus of finance at New York University’s Stern School of Business, analysed companies based on five financial ratios.

  1. Liquidity: the availability of financial assets that can be quickly converted to cash.
  2. Solvency: a measure of the assets possessed by a company that will help in meeting its long-term debts.
  3. Profitability: an indicator of a firm’s ability to sustain its profits in the long-run.
  4. Leverage: how much capital comes in the form of debt?
  5. Activity: how effectively a firm uses its operating assets to convert them into sales or cash.

In a subsequent paper in 2002, Altman examined 86 distressed companies from 1969-1975, 110 bankrupt companies from 1976-1995, and 120 bankrupt companies from 1997-1999. The Z-Score had an astonishingly high accuracy of 82-96%.

The methodology rose to prominence during the 2008 financial crisis when it successfully predicted corporate defaults that ultimately led to the bust of Lehman Brothers.

The Z-Score

Here is how a company’s Z-Score is calculated:

Z-Score (Z) = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where:

A = Working Capital/Total Assets

B = Retained Earnings/Total Assets

C = Earnings Before Interest and Taxes/Total Assets

D = Market Value of Equity/Total Liabilities

E = Sales/Total Assets

The score translates to the financial state of a company as follows:

Z-Score Corporate distress
Z < 1.81 Distress zone (high probability of bankruptcy)
Z is between 1.81 and 2.99 Grey zone (moderate chance of bankruptcy)
Z > 2.99 Safe zone (negligible chance of bankruptcy)

Indian context

Does the Z-Score work in the Indian context? Let us undertake an analysis of a few stocks.

The stocks selected are either on the verge of bankruptcy or under tremendous financial stress. To avoid any confirmatory bias; every stock is being put under the scanner based on their annual reported financial figures as of March 2018—well before their troubles started making headlines.

  1. Infrastructure Leasing & Financial Services: IL&FS, which lent to infrastructure companies, was the harbinger of India’s shadow banking crisis. In September 2018, the company defaulted on its payments, which spelt trouble for its many investors, which included banks, insurance companies, and mutual funds.
    Z-Score = 1.2*(-0.254) + 1.4*(-0.031) + 3.3*(0.073) + 0.6*(0.071) + 1*(0.352) = 0.29
  2. Dewan Housing Finance Ltd: DHFL has been a victim of the double whammy of a liquidity crunch and financial irregularities. In June this year, the company delayed interest rate payments, which hit mutual funds that had lent to it. Initially, its troubles were considered a casualty of the IL&FS crisis, but lately, after a forensic audit, massive irregularities by promoters have been highlighted.
    Z-Score = 1.2*(0.939) + 1.4*(0.082) + 3.3*(0.089) + 0.6*(0.164) + 1*(0.101) = 1.73
  3. Cox & Kings: The travel and tourism company is undergoing insolvency proceedings after it defaulted numerous times on its loans this year due to a liquidity crisis. The International Air Transport Association (IATA) has terminated its licence to sell air tickets.
    Z-Score = 1.2*(0.167) + 1.4*(0.297) + 3.3*(0.091) + 0.6*(0.621) + 1*(0.595) = 1.88
  4. Reliance Communications: The Anil Ambani-led Reliance Group company’s plight is one of the many high-profile bankruptcy cases in India. The telco was plagued by intense price wars, ballooning debt, and plunging profitability. In March this year, Anil Ambani nearly faced a jail term for non-payment of dues to equipment maker Ericsson.
    Z-Score = 1.2*(-0.094) + 1.4*(0.019) + 3.3*(0.002) + 0.6*(0.084) + 1*(0.062) = 0.03
  5. Adlabs Entertainment: The owner of the Adlabs Imagica theme park, has been struggling to pay off its loans after it took up massive debt while constructing hospitality-based assets. Its loans were declared as non-performing assets in June 2018.

Z-Score = 1.2*(-0.084) + 1.4*(0.193) + 3.3*(-0.018) + 0.6*(0.349) + 1*(0.142) = 0.46

From the above computations, it can be deciphered that the Z-Score is significantly effective and accurate at predicting corporate bankruptcies across sectors.

More often than not, the triggers for bankruptcy of a corporate are hard to predict, but what is guaranteed to produce a downward spiral for the company is the absence of solid core fundamentals: Z-Score aims to foretell such capital-eroding facades.

We welcome your comments at ideas.india@qz.com.

 

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