Predicting future business performance is necessary to estimate probable sales, income, costs, and profitability and thus gain investment and maintain confidence in the company.

How it works

Forecasting success or failure relies on historical data—financial statements, financial ratios, and Key Performance Indicators—that reflect business operation and can be tracked over time. The tracked and monitored data can provide an early warning system for potential problems. For small businesses and start-ups, accurate forecasts provide a basis for raising external financing, while for larger companies, this information provides an indication of financial strength for investors and markets. Predictions may range from conjectured costs and revenue to complex financial models. One of the most frequently used predictive models for forecasting business success is the Z-score model, devised by Edward Altman, a New York University finance professor, in 1968.

Forecasting with Z-score models

Realizing that traditional financial ratios, such as the ratio of costs to revenue, created only a partial picture of a business’s financial performance, Altman devised a set formula that combined four or five key ratios to give a Z score. The model has proven 90 percent accurate in predicting business failure over one year, and 80 percent accurate over two years.

Corporate success

Efficiently run companies with a healthy balance between assets and liabilities, and profit and debt inspire confidence in investors.

Working capital / total assets A measure of liquidity: the
more working capital in a company, the more it is able to pay its bills.

Market value of equity / book value of total liabilities A measure of the market confidence in the company: a ratio of less than one means the firm is worth less than it owes—it is insolvent.

Retained earnings / total assets A measure of leverage: a high ratio indicates profits are funding growth; a low ratio indicates growth is financed by debt.

Earnings before interest and taxes / total assets A measure of return on assets: it gauges operating income generated by assets.

Sales / total assets A measure of efficiency: the
sales generated by the assets.

Finding the Z score

Each of the above ratios is multiplied by a specific value, to give them weighting; results are added together to give Z score

❯ A score of 0.2 or lower means the company is highly likely to fail.

❯ A score of 0.3 or higher means the company is unlikely to fail.

Signs of corporate failure

There are many signs that a company is doing badly and perhaps sliding into insolvency. These signs make investors nervous, which is likely to lower share price if they start selling their shareholding. However, most companies that fail are in profit, but run out of cash.

Low cash flow seen in continued fashion of decline in cash holding on Balance sheet over consecutive years

Selling assets to pay off debt

Cuts to employee benefits

Reapeted devidend cut to shareholders

Top management resigning and taking jobs elsewhere

Low profitability, seen in consistent downslide in profit on profit-and-loss statements from consecutive years

High borrowing, high interest payments, and dwindling revenue

Bankruptcy occurs if the company cannot pay its debts

NEED TO KNOW

❯ Ohlson O score Alternative to Z score for predicting failure

❯ Overtrading When a company’s sales grow faster than its finance

❯ Undertrading When a company trades at low levels compared to its finance levels

❯ Zeta analysis Secondgeneration Z-score model

20%
the predicted profitability increase from 2013 to 2017
for organizations using performance measurement to make business forecasts