Predicting Financial Distress What is Financial Distress? Operating cash flows insufficient to satisfy current obligations and the firm is forced to take corrective action Stock-based insolvency» Occurs when the value of assets < value of promised payments to debt Flow-based insolvency» Occurs when operating cash flows are insufficient to cover contractually required payments. FIN 551: Fundamental Analysis 2 FIN 551: Fundamental Analysis 1
Insolvency Solvent Firm Insolvent Firm Stock-Based Insolvency Assets Debt Equity Assets Debt Flow-Based Insolvency $ Negative equity Cash flow shortfall Contractual obligation Firm cash flow Insolvency FIN 551: Fundamental Analysis 3 Prediction Models First stop: Forecast a firm s debt rating Why bother?» S&P rating changes lag Next stop: Forecast bankruptcy Altman s Z-score models Emery s lambda index model. FIN 551: Fundamental Analysis 4 FIN 551: Fundamental Analysis 2
CCC75.4 S&P Debt Ratings S&P % of Public Firms Pre-tax Return LT Capital Median Ratios 1991-1993 Pre-tax Interest Coverage NWC / Total debt LT Debt / Total Capital AAA 1.2% 24.5% 19.9 136.8% 11.0% AA 5.4% 18.4% 8.9 75.1% 19.3% A 16.2% 13.7% 4.7 44.3% 30.9% BBB 19.5% 9.7% 2.5 29.3% 39.5% BB 26.1% 9.6% 1.6 17.9% 50.5% B 28.6% 6.4% 0.7 8.5% 58.9% CCC 1.1% 5.5% 0.5 1.5% 75.4% FIN 551: Fundamental Analysis 5 Prediction of Debt Ratings Kaplan & Urwitz Models Coefficients Variable Model 1 Model 2 Intercept 5.67 4.41 Total assets 0.0010 0.0012 1 = subordinated debt; 0 = unsubordinated -2.36-2.56 LT debt / total assets -2.85-2.72 Market model beta -0.87 n.a. NI / total assets 5.13 6.40 σ market model residual -2.90 n.a. CV in NI (5 yrs.) n.a. -0.53 EBIT / interest 0.007 0.006 Predictions Score > 6.76 = AAA; Score >.5.19 = AA; Score > 3.28 = A; Score > 1.57 = BBB; Score < 0 = BB FIN 551: Fundamental Analysis 6 FIN 551: Fundamental Analysis 3
Predicting Bankruptcy: Altman s Z-Score Models Private + Non-mfr. Firms Z = 6.72 * EBIT / Total assets + 6.56 * NWC / Total assets + 1.05 * BV equity /BV debt + 3.26 * Total retained earnings / Total assets Prediction Z < 1.23 Bankruptcy looming 1.23 < Z < 2.90 Gray area Z > 2.90 No bankruptcy Public Mfr. Firms Z = 3.3 * EBIT / Total assets + 1.2 * NWC / Total assets + 0.6 * MV equity / BV debt + 1.4 * Total retained earnings / Total assets + 1.0 * Sales / Total assets Prediction Z < 1.81 Bankruptcy looming 1.81 > Z < 2.99 Gray area Z > 2.99 No bankruptcy FIN 551: Fundamental Analysis 7 ZETA Model Proprietary model Zeta is negatively correlated with Barra s fundamental betas and Value Line s financial strength score Variables»ROA» Standard deviation of ROA over 5 years» Interest coverage ratio» Retained earnings / total assets (most important)» Current ratio» Equity / total capital ratio (average 5 years)» Tangible assets. FIN 551: Fundamental Analysis 8 FIN 551: Fundamental Analysis 4
Keep in Mind Most prediction models have inherent flaws Derived on a limited sample Derived for a certain period of time» These problems exist with the bond rating model and Altman s bankruptcy Z-score models When using the models, ask yourself: Is the model still valid? Emery s lambda index model is statistically better. FIN 551: Fundamental Analysis 9 Emery s Lambda Index Lambda Index = Liquid reserve + expected CF CF uncertainty Liquid reserve = Cash + marketable securities + available lines of credit Expected CF = Net cash flow expected to be received or paid during the period CF uncertainty = σ net cash flow for the period. FIN 551: Fundamental Analysis 10 FIN 551: Fundamental Analysis 5
Why the Lambda Index? Includes cash flows and lines of credit Excludes illiquid items Recognizes uncertainty Although different, it s a coverage ratio Provides estimate of likelihood of insolvency. FIN 551: Fundamental Analysis 11 Does It Work? Results of a test on 52 bankrupt and 52 solvent companies: Years Percent Average Lambda Values Before Correctly Failed Solvent Failure Classified Companies Companies 5 81% 0.42 4.43 4 90% 0.19 4.95 3 93% 0.03 5.46 2 93% - 0.66 6.78 1 94% - 2.30 9.10 Source: Gary W. Emery and Kenneth O. Cogger, The Measurement of Liquidity, Journal of Accounting Research, Autumn 1982, pp. 290-303. FIN 551: Fundamental Analysis 12 FIN 551: Fundamental Analysis 6
Calculating the CF Variables Actual Actual CF - (Actual CF - Expected Year Cash Flow Expected CF CF) Squared 1991 $ 69.2 $ - 106.9 $ 11,427.6 1992 729.0 552.9 305,698.4 1993-641.2-817.3 667,979.3 1994 877.7 701.6 492,242.6 1995-154.0-330.1 108,966.0 Sums $ 880.7 $ 1,586,313.9 Expected CF = $880.7 / 5 = $176.1 σ CF = SQRT($1,586,313.9 / 4) = $629.7 What about deducting necessary investments to maintain competitiveness in markets; i.e., use FCF? FIN 551: Fundamental Analysis 13 Likelihood of Insolvency in 95 Cash & securities 1995 = $952 Expected cash flow = $176.1 σ of cash flows = $629.7 Lambda = $952 + $176.1 = 1.79 $629.7 Estimated likelihood of insolvency = 1 - N(lambda) = 1-0.9634 = 0.0366 or 4%. Taken from a probability table for the normal distribution FIN 551: Fundamental Analysis 14 FIN 551: Fundamental Analysis 7
Apple s Lambda Using Historical Cash Flow From Operations Lambda 6 5 4 3 2 1 0 1990 1991 1992 1993 1994 1995 FIN 551: Fundamental Analysis 15 Apple s Lambda Using Historical Cash Flow From Operations 6 5 Lambda 4 3 2 Trend 1 0 1990 1991 1992 1993 1994 1995 FIN 551: Fundamental Analysis 16 FIN 551: Fundamental Analysis 8
The End FIN 551: Fundamental Analysis 17 FIN 551: Fundamental Analysis 9