Evaluating Your Company’s Performance

Most manufacturers are keenly interested in how they are performing financially. While business owners usually have a
sense of how they are doing, the application of objective tools to assess a company’s financial strengths and weaknesses
can be invaluable.

One such tool is ratio analysis. Calculating financial ratios for your company (such as debt-to-equity or current assets-to-
current liabilities) and comparing them to industry averages or other benchmarks can provide useful measures of your
company’s performance.

A drawback to ratio analysis is that the various ratios are influenced by a number of factors, and different ratios often
produce dramatically different pictures of a company’s financial health. For many companies, it may be more useful to
apply a single financial model that measures a company’s overall performance, such as the Z-score.

The Z-score was developed in the sixties by Edward Altman of New York University to help companies predict
bankruptcy. However, it is also useful in measuring financial performance in healthy companies. Altman analyzed the
financial statements of several dozen manufacturing companies, about half of which had filed for bankruptcy. The Z-score
originally consisted of five weighted financial ratios that when combined could be used to distinguish the bankrupt
companies from the nonbankrupt companies in the study. (The original five ratios were working capital/total assets,
retained earnings/total assets, EBIT/total assets, net worth/total liabilities, and sales/total assets.)

Altman later developed a “four-variable” version of the Z-score that eliminated sales/total assets from the equation. We
recommend use of the four-variable version because consideration of sales can artificially inflate a company’s Z-score. For
example, a company with high sales but low profit margins might possess a high Z-score despite poor profitability.

Computing Your Z-Score

Begin by calculating the following four ratios using information from your financial statements:
X1 = Working Capital
Total Assets
This ratio measures liquidity. Working capital is defined as current assets minus current liabilities. In financially troubled
companies, working capital tends to drop more quickly than total assets, causing this ratio to decline.
X2 = Retained Earnings
Total Assets
This ratio measures profitability. In distressed businesses, this ratio may be a negative number.
X3 = EBIT
Total Assets

The ratio of EBIT (earnings before interest and taxes) to total assets (i.e., your return on total assets) demonstrates how
effectively your company makes use of its assets.
X4 = Net Worth
Total Liabilities

The ratio of net worth (or stockholders’ equity) to total liabilities is simply the inverse of debt-to-equity.

Once these four ratios are computed, your Z-score can be determined by applying the following formula: Z-score =
6.56(X1) + 3.26(X2) + 6.72(X3) + 1.05(X4) (see Figure 1).

A Z-score over 2.60 indicates a healthy company. If your Z-score is less than 1.10, you may be headed for trouble (see
Figure 2).

© 2009 Principa. All Rights Reserved. 16

 Evaluating Your Company’s Performance

Using the Z-Score

The Z-score’s value is not limited to warning companies of imminent bankruptcy. Healthy companies should periodically calculate
their Z-scores and look for trends or signs of financial problems that may call for remedial action. The Z-score can also help you
identify what sort of action is needed. For example, if a low or declining Z-score is due to a low ratio of working capital to total
assets, the company might consider selling off obsolete equipment or inventory. This action would increase working capital and
reduce assets, thereby increasing ratio X1 (as well as X2 and X3).

Calculating your Z-score is easy and can provide you with valuable information about how your company is doing and guidance on
improving performance. However, although the Z-score has proven to be a reliable indicator of financial performance for many
companies, it is not infallible. The Z-score should be used to complement but not replace other methods of financial analysis.

Figure 1
Z-Score Computation
Weight Weighted
Ratio Calculation Factor Ratio
X1 Working Capital X 6.56 =
Total Assets _________
X2 Retained Earnings X 3.26 =
Total Assets _________
X3 EBIT X 6.72 =
Total Assets _________
X4 Net Worth X 1.05 =
Total Liabilities _________

Z-Score =

Figure 2
Z-Score Rating
Z-Score Rating
Less than 1.10 Bankruptcy Likely
1.10 to 2.60 Indeterminate
Over 2.60 Healthy Company

© 2009 Principa. All Rights Reserved. 17