Account for the varied causes of financial distress at firms and pinpoint possible signs that it is occurring.
The idea
Financial distress means a firm cannot meet its obligations as they fall due. It is flow-based when cash flow is too small to pay interest and principal, and stock-based when liabilities exceed the value of assets. Causes fall into several groups: economic distress (a declining industry, lost competitiveness, assets earning less than their cost of capital), excessive leverage on an otherwise viable business, weak management or governance, fraud, and external shocks such as a credit squeeze. Warning signs include covenant breaches, rating downgrades, widening credit spreads and a falling share price, a going-concern opinion from the auditor, suppliers tightening terms, late payments, and profits that are not backed by operating cash flow. The Altman Z-score combines five ratios. A score below 1.81 signals distress and above 2.99 safety. For the exam, separate the cause (economic versus financial) from the symptom.
Formulas
Altman Z-score (original)
Z = 1.2 × X₁ + 1.4 × X₂ + 3.3 × X₃ + 0.6 × X₄ + 1.0 × X₅
- X₁
- working capital ÷ total assets
- X₂
- retained earnings ÷ total assets
- X₃
- EBIT ÷ total assets
- X₄
- market value of equity ÷ total liabilities
- X₅
- sales ÷ total assets
Below 1.81 signals distress, above 2.99 safety, and in between is a grey zone. X₄ uses the market value of equity over liabilities, not over assets.
A practice question
Which of the following is most typically a symptom of rising financial distress at a manufacturing firm?
- Operating margin rises while receivable days and inventory days stay unchanged over several quarters.Why not: Healthy operating indicators are not distress symptoms; stable collections plus higher margin point the other way.
- The cash balance grows while total borrowings are unchanged.Why not: Rising liquidity with constant debt reduces, not increases, the risk of default.
- Equity return volatility falls following an earnings announcement.Why not: Lower volatility after news is a market reaction, not evidence of payment difficulty; distress usually brings higher volatility.
- Suppliers move the firm to cash on delivery. - correct
Suppliers who tighten credit terms are reacting to a perceived higher default risk, a classic trade-credit warning sign. The other options describe stable or improving conditions.
A harder one
A firm's EBITDA has been stable for ten years and its products remain in demand. After a leveraged recapitalization its debt is 8 times EBITDA, and it cannot refinance a bond maturing in three months because credit markets have tightened. Which description of the cause of its difficulty fits best?
- Financial distress from excessive leverage and refinancing risk; the business is viable. - correct
- Economic distress, because the firm's business model has been made obsolete by structural industry decline.Why not: Misreads a stable EBITDA and demand as industry decline; the problem here is the capital structure, not the assets.
- Distress caused by management fraud that has overstated reported earnings.Why not: Introduces fraud that the scenario never mentions; stable EBITDA and a refinancing failure point to leverage.
- Operational inefficiency, to be fixed mainly by closing plants and cutting headcount.Why not: Confuses an operational cause with a financial one; cost cuts do not remove a maturity the firm cannot refinance.
The assets still earn their keep (stable EBITDA, demand intact), so the trouble is the 8x leverage and a refinancing wall in a tight market. That is financial rather than economic distress, which affects which remedy (debt restructuring) is sensible.
The hardest tier
An industrial firm has total assets of 500 and total liabilities of 300. Its market value of equity is 120. Working capital is 25, retained earnings 10, EBIT 20 and sales 450. Use the original Altman Z-score, Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5, where X1 = working capital / total assets, X2 = retained earnings / total assets, X3 = EBIT / total assets, X4 = market value of equity / total liabilities and X5 = sales / total assets. Distress zone is below 1.81, grey zone 1.81 to 2.99, safe zone above 2.99. Which result is correct?
- Z is about 1.96, which is in the grey zone.Why not: Computes X5 as sales / total liabilities (1.5) instead of sales / total assets (0.9).
- Z is about 3.34, which is in the safe zone.Why not: Swaps the coefficients on X3 and X5, giving sales the 3.3 weight and EBIT the 1.0 weight.
- Z is about 2.62, which is in the grey zone.Why not: Inverts X4 as total liabilities / market equity (2.5) instead of market equity / total liabilities (0.4).
- Z is about 1.36, which is in the distress zone. - correct
X1 = 0.05, X2 = 0.02, X3 = 0.04, X4 = 120/300 = 0.40, X5 = 450/500 = 0.90. Z = 0.060 + 0.028 + 0.132 + 0.240 + 0.900 = 1.36, below 1.81, so the firm is in the distress zone.
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