Financial Distress

Essentials of Corporate
Finance, 5th edition, A.A.
Finance, Stephen Ross,
Groppelli and Ehsan Nikbakht
Randolph Westerfield,
Essential
Bradford Jordan, Jorg Bley
What is Financial Distress?
Corporate financial distress is generally associated with failure, insolvency, default, and
bankruptcy.

Failure Costs exceed revenues.

Insolvency A firm is incapable of covering its obligations.

Default A firm fails to meet periodic payments on debt.

An indication that the firm is in financial distress and requires legal

Bankruptcy action.
Bankruptcy Prediction Models

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Altman’s Z-Score

Altman’s Z-Score is based on five financial ratios using the following formula

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

Working capital Current assets Current liabilities

A
Total assets

Retained earnings
B
Total assets

Earnings before interest and taxes

C
Total assets
Altman’s Z-Score

Altman’s Z-Score is based on five financial ratios using the following formula

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

Market value of equity # of shares Market price per share

D
Total liabilities

Sales
E
Total assets

The firm is financially sound. There is a low likelihood of financial

Z-Score > 2.67
distress.

Z-Score < 1.81 A score less than 1.81 suggests financial distress.
 Example
Harris Pilton has total assets of $4,000,000 and working capital of $4,000,000. The firm’s
retained earnings balance is $2,000,000. The income statement shows earnings before
interest and taxes of $8,000,000 and sales of $16,000,000. The market value of equity is
$3,000,000 and total liabilities amounts to $1,000,000. Using Altman’s Z-Score, determine
whether this firm is financially distressed.

4,000,000 2,000,000 8,000,000 3,000,000 16,000,000

Z-Score 1.2( ) 1.4( ) 3.3( ) 0.6( ) 1.0( )
4,000,000 4,000,000 4,000,000 1,000,000 4,000,000
1.2 0.7 6.6 1.8 4

Z-Score 14.3

Since Altman’s Z-Score is 14.3 which is well above 3.0, this firm is unlikely to go bankrupt in the
near future.

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Distress/Non-Distress Classification

A company is financially distressed if it exhibits at least one of the following signals:

Negative working capital in the most recent year.

A bottom-line net loss in the most recent year.

Both negative working capital in the most recent year and net loss
experienced in the most recent year.

Negative operating cash flow

Both negative operating cash flow and a bottom-line net loss in the most
recent year.
Qualitative Measures

Analysts can also observe qualitative measures which give signals of financial distress.

Reduction in dividend
Credit rating decrease
payments

Debt default announcement Violation of debt covenants

Going concern audit opinion Debt restructuring

Applying Statistics in Financial Research

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Regression Analysis

A linear regression estimates the relationship between one variable referred to as the dependent variable and one
or more other variables referred to as independent variables. Regression helps us make predictions about the
dependent variable by analyzing how the independent variables affect it. Linear regression can show us, for example,
that a positive relationship exists between Altman’s Z-Score (dependent variable in this example) and firm size
(independent variable in this example). This tells us that as firm size increases, profitability increases. Regression
analysis output will give us a coefficient and a p-value for each independent variable.

The coefficient tells us the relationship between the independent variable and the dependent variable.
A positive coefficient means there is a positive relationship. When the independent variable increases,
the dependent increases as well. A negative coefficient means there is a negative relationship. When
the independent variable increases, the dependent variable decreases.

The p-value tells us the statistical significance of the relationship. In other words, how confident we are
that the result did not come about through chance. A small p-value (less than 0.05) indicates that the
result is unlikely to have occurred by chance, while a large p-value indicates insufficient evidence to
reject the null hypothesis.

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Regression Analysis
The following is an example of a linear regression output investigating the impact of profitability, leverage, dividend
payout, liquidity, asset tangibility, the price-book ratio, and firm size on Altman’s Z-Score (the dependent
variable in this example).

According to this example, only ROA, leverage, the price-book

ratio, and firm size have p-values that are less than 0.05.
Therefore, we are only confident in the results of these
variables. ROA, the price-book ratio, and firm size are
positively associated with Altman’s Z-Score. However,
leverage is negatively associated with Altman’s Z-Score. This
means that as ROA, the price-book ratio, and firm size
increase, Altman’s Z-Score increases as well, reflecting on
lower financial distress. However, as leverage increases,
Altman’s Z-Score decreases, reflecting on higher financial
distress.

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End of Lecture!
Any questions?
You can find me at:
▪ [email protected]

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