Suppose that the financial ratios of a potential borrowing firm took the following values: X₁ = Net working capital/Total assets = 0.05, X₂ = Retained earnings/Total assets = 0.12, X₃ = Earnings before interest and taxes/Total assets = 0.17, X₄ = Market value of equity/Book value of long-term debt = 0.42, X₅ = Sales/Total assets ratio = 0.6. Calculate and interpret the Altman's Z-score for this firm. A) 1.64; High risk B) 1.64; Indeterminate C) 1.99; Low risk D) 2.79; Indeterminate

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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: Z = 1.2(0.05) + 1.4(0.12) + 3.3(0.17) + 0.6(0.42) + 1.0(0.6) = 1.64. A Z-score below 1.8 indicates high risk of bankruptcy.

Suppose That the Financial Ratios of a Potential Borrowing Firm