What it means
Bankruptcy analysis has two sides. The first is prediction, which asks whether a company is heading towards failure and how soon.
The second is recovery, which asks how much money lenders and other creditors (those owed money) would get back if the company were wound up or restructured. For prediction, analysts look at warning signs in the accounts.
Falling profits, shrinking cash, rising debt, slower customer payments and heavy reliance on short-term borrowing all raise the risk. Many also use scoring models, the best known being the Altman Z-score, which combines five ratios into one number that places a company in a safe, grey or distressed zone.
For recovery, the analyst builds a picture of what the assets would fetch if sold in a hurry and compares it with what is owed. Secured lenders, who hold a legal claim over specific assets, are paid first.
Unsecured creditors such as suppliers, and finally shareholders, stand behind them and often recover little or nothing. Business teams use this analysis in everyday decisions.
A sales director may use it to decide how much credit to give a new customer, and a purchasing manager may use it to check whether a key supplier could collapse. A finance team may use it to test its own business before asking a bank for a loan.
The main nuance is that a model is a screening tool, not a verdict. Scores can mislead for service companies, start-ups and firms in unusual industries, because the models were built using particular groups of businesses.
Good practice is to treat the score as a prompt for deeper questions about cash, contracts and management.
In practice
Real-world examples
Example 1
A credit controller at a packaging supplier runs a Z-score on a customer asking for $150,000 of credit. The score falls in the distress zone, so she asks for payment on delivery and a smaller limit. Two quarters later the customer enters formal insolvency and the supplier avoids a large loss.
Example 2
A private equity analyst reviews a retail chain that is burning cash. She compares the value of the inventory and property with the debts and estimates that secured lenders would recover about 80 cents on the dollar. That estimate shapes the price she is willing to offer for the chain's debt.
Example 3
The finance director of a software company prepares for a bank meeting. She runs the same tests the bank will use, spots that short-term debt has crept up, and refinances part of it into a longer loan before the meeting. The bank sees a stronger business and agrees better terms.
Think of it
Bankruptcy analysis is like a doctor assessing whether a patient might need emergency intervention. You're looking for warning signs.
Formula
Calculation
Altman Z-score (original version for listed manufacturers) = 1.2 x A + 1.4 x B + 3.3 x C + 0.6 x D + 1.0 x E
A = Working capital / Total assets; B = Retained earnings / Total assets; C = EBIT (earnings before interest and tax) / Total assets; D = Market value of equity / Total liabilities; E = Sales / Total assets.
Suppose a company has total assets of $5,000,000, working capital of $500,000, retained earnings of $1,000,000, EBIT of $400,000, market value of equity of $2,700,000, total liabilities of $3,000,000 and sales of $6,000,000. A = 0.10, B = 0.20, C = 0.08, D = 0.90 and E = 1.20.
Z = (1.2 x 0.10) + (1.4 x 0.20) + (3.3 x 0.08) + (0.6 x 0.90) + (1.0 x 1.20) = 0.12 + 0.28 + 0.264 + 0.54 + 1.20 = 2.404. Under the original model, a score below 1.81 signals distress, above 2.99 signals safety, and between the two is the grey zone, so this company sits in the grey zone and deserves closer monitoring.Case study
Seen in the real world
Marlowe Textiles is a fictional clothing manufacturer that grew fast on short-term borrowing. Its lender ran a bankruptcy analysis after sales slipped for two quarters and found that the Z-score had dropped from 3.1 to 1.7. The analysis also showed that inventory would sell for only about half its book value in a forced sale.
Based on this illustrative analysis, the lender did not call in the loan. Instead it agreed a restructuring in which Marlowe sold a spare factory, paid down $2,000,000 of debt and reported cash flow every month. Eighteen months later the score had recovered above 2.5, and the lender kept a customer rather than taking a loss.
Watch out
Common mistakes
- Treating a Z-score as a guaranteed prediction. It is a risk indicator based on past patterns, so companies in the distress zone can survive and those in the safe zone can still fail.
- Using a manufacturing model on a service or technology business without adjusting it. Different industries have different asset structures, so use a version designed for the sector.
- Looking only at profit. Many failing firms report profit but run out of cash, so cash flow and debt maturity matter just as much.
Questions
People also ask
What is the difference between bankruptcy and insolvency?
Insolvency is the financial state of being unable to pay debts, while bankruptcy is usually the formal legal process that follows, although terms vary by country.
Who uses bankruptcy analysis?
Lenders, credit insurers, suppliers, investors, auditors and company managers all use it to assess risk.
What are the warning signs of bankruptcy?
Common signs include falling cash, missed payments, covenant breaches, rising short-term debt, delayed accounts and key staff leaving.
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