Suppose that the financial ratios of a potential borrowing firm took the following values: X₁ = Net working capital/Total assets = 0.15, X₂ = Retained earnings/Total assets = 0.27, X₃ = Earnings before interest and taxes/Total assets = 0.28, X₄ = Market value of equity/Book value of long-term debt = 0.68, X₅ = Sales/Total assets ratio = 0.9. Calculate and interpret the Altman's Z-score for this firm. A) 1.92; Low risk B) 2.01; Indeterminate C) 2.79; Low risk D) 2.79; Indeterminate

Question

Quizplus · Accepted Answer

Altman's Z-score is calculated using the formula: Z = 1.2(X1) + 1.4(X2) + 3.3(X3) + 0.6(X4) + 1.0(X5), where X1 = Net working capital/Total assets, X2 = Retained earnings/Total assets, X3 = Earnings before interest and taxes/Total assets, X4 = Market value of equity/Book value of long-term debt, and X5 = Sales/Total assets ratio. Substituting the given values, we get Z = 1.2(0.15) + 1.4(0.27) + 3.3(0.28) + 0.6(0.68) + 1.0(0.9) = 0.18 + 0.378 + 0.924 + 0.408 + 0.9 = 2.79. A Z-score of 2.79 falls into the "indeterminate" zone (1.8 < Z < 3), indicating that it's not clear whether the firm is at high risk of bankruptcy or not.

Suppose That the Financial Ratios of a Potential Borrowing Firm