Altman Z score is used to recognize bankruptcy possible of firms. However, the initial model created by Altman does not assist in predicting bankruptcy of banks. For that, we will need to use Altman’s customised model for banks.
Hypothetical illustration
Given, economic information (Rs crore) of Pranaya Piyush Bank (PP): Earnings Before Interest & Tax (EBIT) 5,000 total assets 50,000 working capital (10,000) retained earnings 7,000 income 10,000 book worth of debt 30,000 market place capitalisation 90,000.
Altman Z Score for banks
Altman created the Z score as a tool for predicting the bankruptcy of a bank. Z score is computed as the sum of 6.56 (working capital/total assets) +3.26 (retained earnings/total assets) +6.72 (EBIT/total assets) +1.05 (market place worth of equity/book worth of debt) + 3.26. Higher the score of a bank in these variables, the superior is its security margin for investors. If the Z score is much less than 1.10, the bank is a bankruptcy candidate if Z score is above 2.60, the bank is out of the bankruptcy threat if Z score is in between 1.10 and 2.60, the bank is in the gray zone and it is tough to predict its bankruptcy possibility. Sales to total asset ratio applied in the model for manufacturing firms is not viewed as in the model for banks. Further, 3.26 is added to adjust for emerging market place banks.
Working capital/total assets
For PP, it is (.20 instances) (unfavorable working capital of Rs 10,000 crore/total assets of Rs 50,000 crore). If its earlier period ratio is (.30) instances, then it has enhanced its overall performance in the existing year. The weighted score is -1.31. For banks, generally existing liabilities exceed existing assets. So they have unfavorable working capital.
Retained earnings/total assets
For PP, it is .14 instances (= retained earnings of Rs 7,000 crore/ total assets of Rs 50,000 crore). If its earlier period ratio is .10 instances, then the bank has enhanced its overall performance in the existing year. The weighted score is .46 (= 3.26 * .14).
EBIT/total assets
For PP, it is .10 instances (Rs 5,000 crore/ Rs 50,000 crore). If its earlier period ratio is .20 instances, then the bank has fallen in its overall performance in the existing year. The weighted score is .67(= 6.72 * .10).
MV of equity/BV of debt
For PP, it is 3 instances (market place cap of Rs 90,000 crore/ BV of debt of Rs 30,000 crore). If its earlier period ratio is 2.5 instances, then the bank has enhanced its solvency position. The weighted score is 3.15.
The Z score of PP is 2.97 (without having adding 3.26 for emerging markets) and 6.23 (with addition of 3.26) which indicates that it is a safer bank for investors. Though the coefficients might transform if we run the model working with existing information, the inter and intra comparison of a bank in these 4 variables might provide more clarity on the economic overall performance of a bank.
The writer is associate professor of Finance at XLRI – Xavier School of Management, Jamshedpur