Intuitive Understanding
<<there isn't really anything very direct in there about debt: just the working capital and the ratio of equity to liabilities.>>
John: I think the best proxy in the equation for Debt is Total Assets, which forms the denominator for four of the five variables in the Altman Z-score (i.e., X1, X2, X3, and X5). Given the prevalence of Total Assets throughout the formula, one quickly realized that a quick way to increase a company's Z-score is to reduce Total Assets, and vice versa. In practice, this is what turnaround professionals often do in a turnaround engagement... reduce total assets by converting to cash and paying down debt. If you look at the formula from this perspective, it appears to be a lot more intuitive.
<<One thing in it that really puzzles me, and apparently you too, Razorbak, is the retained earnings. It is a long-term historical indicator that has nothing to do with the short-term prospects of whether the co. can stay afloat.
Lots of development stage companies have huge negative retained earnings and they stay afloat by issuing equity repeatedly. This is a sustainable situation provided that the market cap stays high enough compared to the cash burn: typically they need a market cap of 10X the cash burn. That really is how development stage companies stay out of bankruptcy. The company's market cap is the one things that stands between a development stage co. and bankruptcy. I don't see any way that Altman's model deals with this reasonably.>>
Two excellent points. I'll attempt to address each one separately.
Regarding the issue of Retained Earnings, I think there is probably a very high correlation between Retained Earnings and bankruptcy. Otherwise that particular variable wouldn't have survived the multiple cuts of lesser predictive variables throughout the model's development. If you think about it, the issue of earnings in general (and, even more to the point, cash flow from operations) is fundamentally important in determining a company's long-term viability. However, since EBIT only takes a snapshot over an annual period, it is more of a short term indicator. Retained Earnings, as you acknowledge, is a long term indicator. Since companies often take several years to decline through the "in danger" zone into the "near death" zone, perhaps the Retained Earnings variable provides the best proxy for the long term earnings component of the model?
Regarding the issue of market cap, I think the X4 variable (Market Value of Equity / Book Value of Total Liabilities) provides a reasonable proxy for market cap to cash burn rate within the model. Although it may not be perfect, it must have a relatively high predictive value to have been included in the model. What the X4 variable doesn't account for on the cash burn rate is probably accounted for in a roundabout way via the X1 variable (WC/TA) and the X3 variable (EBIT/TA).
JMO, of course. Input from others on these issues is always welcome.
Like I said, excellent points. Thanks for your input.
Razor |
