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FSA Summary book and lectures

Financial Statement Analysis for E&BE (Rijksuniversiteit Groningen)

Studeersnel wordt niet gesponsord of ondersteund door een hogeschool of universiteit

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Financial Statement Analysis Exam Summary

Chapter 1: A Framework for Business Analysis and Valuation Using Financial

Statements

Financial statement analysis: The application of analytical tools and techniques to general
purpose financial statements and related data to derive estimates and inferences useful in
business analysis. Financial statement analysis reduces reliance on hunches, guesses and
intuitions for business decisions. It decreases the uncertainty of business analysis.

Purpose:
- Security analysis
- Credit analysis
- Mergers and acquisitions analysis
- General business analysis
- Audit risk analysis

Although savers and investors want to do business with one another, matching savings to
business investment opportunities through the use of capital markets is complicated:
- Information asymmetry  entrepreneurs have better information than savers, on
the value of investment opportunities
- Potentially conflicting interests  communication by entrepreneurs to savers is not
completely credible as entrepreneurs have an incentive to inflate the value of their
ideas
- Expertise asymmetry  savers lack the financial sophistication to analyze and
differentiate between different business opportunities

Lemons problem: If investors cannot distinguish between good and bad ideas, investors will
value both good and bad ideas at an average level. Entrepreneurs with good ideas may find
the terms on which they can get financing to be unattractive. These entrepreneurs may
leave the market.

Financial intermediaries: banks, pension funds, insurance companies

Information intermediaries: auditors, financial analysts, credit rating agencies

A firm’s financial statements summarize the economic consequences of its business

activities.

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How business intermediaries use financial statements to accomplish four key steps:
1. Business strategy analysis  Chapter 2
- Identifying key profit drivers and business risks
2. Accounting analysis  Chapter 3+4
- Evaluate the degree to which a firm’s accounting captures the underlying business reality.
3. Financial analysis  Chapter 5
- use financial data to evaluate the current and past performance of a firm and to assess its
sustainability
4. Prospective analysis  Chapter 6,7,8

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Chapter 2: Strategy Analysis

1. Industry Analysis  Assessing a firm’s profit potential of each industry in which the firm is
competing because the profitability of various industry differs systematically and predictably
over time.

Degree of actual and potential competition:

- Rivalry among existing firms
o Industry growth rate  if an industry grows rapidly, firms do not need market
shares from another to grow. However, when an industry does not grow
rapidly, firms need market shares from one another to grow.
o Concentration and balance of competitors  The degree of concentration
determines whether firms in an industry can coordinate their pricing and
other competitive moves.
o Excess capacity and exit barriers if capacity is larger than demand, there is
an incentive to cut prices, high exit barriers, if there is specialized assets
o Degree of differentiation and switching costs  if products in an industry are
relatively similar  low switching costs  high competition
o Scale economies and the ratio of fixed to variable costs  high fixed to
variable costs, lower prices, more competition
- Threat of new entrants
o Scale  when there are large economies of scale, new entrants face the
choice of having either to invest in a large capacity which might not be
utilized right away or enter with less than the optimum capacity
o First mover advantage  set industry standards
o Access to channels of distribution and relationships  limited capacity and
high costs of developing new channels can act as powerful barriers to entry
o Legal barriers  patent and copyrights
- Threat of substitute products or services  depends on the price and relative
performance of the competing products or services and on customers willingness to
substitute.

Bargaining power in input and output markets

- Bargaining power of buyers
o Price sensitivity  buyers are more price sensitive when the product is
undifferentiated and there are few switching costs
o Relative bargaining power  depends on the cost to each party of not doing
business with the other party
- Bargaining power of suppliers  Suppliers are powerful when there are only a few
companies and few substitutes available to their customers.

2. Competitive Strategy Analysis

- Cost leadership  low input costs
- Differentiation  unique products

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System of activities: system of activities that fit with the strategy and potentially reinforce
one another, difficult for competitors to imitate

Positioning: carve out profitable subsegment of industry based on particular product, needs
of particular group, particular access and distribution channels

3. Corporate strategy analysis:

- Low transaction costs
- Information asymmetry

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Chapter 3: Accounting Analysis: The Basics

Accounting analysis is to evaluate the degree to which a firm’s accounting captures its
underlying business reality and to undo any accounting distortions. When potential
distortions are large, accounting analysis can add considerable value.

Ideally all assets and liabilities would be measured at fair value; but, for different types of
assets there are no markets available, which makes it very subjective to determine fair value.

Accounting choices: Provide flexibility in how the financial statement preparers depict the
economic reality of different firms.
- Depreciation, amortization, depletion
- Inventories
- Revenue recognition
- Expenditures on assets
Potential sources of noise and bias:
- Rigidity in accounting rules
- Random forecast errors
- Systematic reporting choices made by corporate managers to achieve specific
objectives

Managers Accounting Choices

- Accounting based debt covenants  Managers may make accounting decisions to
meet certain contractual obligations in their debt covenants. Contracts with banks
- Management compensation  Managers compensations often comes from the fact
that their compensation and job security are often tied to reported profits
- Corporate control contests  make accounting decisions to influence investor
perceptions, mergers and takeovers
- Tax considerations  in countries where there is a link between financial reporting
and tax reporting
- Regulatory considerations  to influence regulatory outcomes such as import tariffs
and tax policies, protect domestic industries
- Capital market considerations  to influence the perception of capital markets,
beating earnings forecasts
- Stakeholder considerations  influence the perception of important stakeholders,
demands of labor unions
- Competitive considerations  dynamics of competition in an industry, proprietary
information

Steps in Accounting Analysis

1. Identify the key accounting policies (banks  interest and credit risk management,
retail  inventory management)
2. Assess accounting flexibility  less flexibility is less informative
3. Evaluate accounting strategy
a. Reporting incentives
b. Deviations from the norm
c. Accounting changes

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d. Past accounting errors

e. Structuring transactions
4. Evaluate the quality of disclosure
a. Strategic choices
b. Accounting choices
c. Discussion of financial performance
d. Non-financial performance information  when a firm invests in quality and
Kundenbetreuung
e. Segment information
f. Bad news
g. Investor relations
5. Identify Potential Red Flags
a. Unexplained changes in accounting
b. Unexplained transactions that boost profits  asset sales
c. Unusual increase in trade receivables in relation to sales increases  The
company is relaxing its credit policies or artificially loading up its distribution
channels to record revenues during the current period
d. Unusual increase in inventories in relation to sales  could be a sign that
demand for the products is slowing down
e. Increasing gap between a firm’s reported profit and its cash flow from
operating activities
f. Increasing gap between a firm’s reported profit and its tax profit
g. Tendency to use financing mechanisms like research and development
partnerships
h. Unexpected large asset write offs
i. Large year end adjustments
j. Qualified audit opinions or changes in independent auditors that are not well
justified
k. Poor internal grade governance mechanisms
l. Related party transactions or transactions between related entities
6. Recast Financial statements and undo accounting distortions
a. Using a standard template
b. In the case of detecting financial reporting distortions, analysts should reduce
the misstatements

Standardized financial statements

- Operating investment and financing activities
o Cash flow statement, financial and operating results
- Current and non-current assets/liabilities
o Discounting
- Continued and discontinued operations
o Predicting future earnings
- Recurring and non-recurring activities
o Predicting future earnings

Note: Conservative accounting is not always good, Unusual accounting is not always bad,
Mind firms business strategy, Accounting standards are not the same as practices.

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Chapter 4: Accounting Analysis, Accounting Adjustments

Identify and undo accounting distortions: Analyzing the elements of the balance sheet for
possible distortions allow the analyst to better understand the economic substance of a
firm’s transactions and financial position

 Balance sheet approach

Asset Distortions: Resources owned/controlled by the firm with probable future benefits
that can be measured reliably
- Doubt about whether the firm owns/controls the resource
- Doubt about future economic benefits that can be measured with certainty
- Doubt about whether fair value estimates are accurate (impairment)

Common forms of overstating assets

- Understated depreciation and amortization
- Impairment
- Leased assets
- Intangible assets
- Accelerated timing of revenue recognition
- Allowances
- Delayed write down of current assets
- Deferred tax

Common forms of understating assets

- Non-recognition of deferred tax asset
- Overstated allowances
- Discounted receivables

Liability Distortions: Economic obligations arising from benefits received in the past for
which the amount and timing is reasonably certain
- Harsh liabilities: Recognized on the balance sheet
- Provisions: recognized on the balance sheet
- Contingent liabilities: not recognized on the balance sheet

The shorter the term of the liability the less room for manipulation. The softer the liability
the more room for manipulation.

Understated liabilities may arise from

- incentives to overstate earnings or the strength of financial position
- difficulties in estimating the amount of future financial commitments

Common forms of liability understatement:

- aggressive revenue recognition, unearned revenues
- understatement of proviions
- leasing
- pension and post retirement obligation understatements

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Equity Distortions:
- equity is the residual claim on a firm’s assets held by stockholders, distortions on
assets and or liabilities lead to distortions in equity

Recasting financial statement sis an important step to facilitate comparability among

financial statements analyzed
Analysts should focus on evaluating and adjusting accounting measures that describe the
firms key strategic value drivers
It is important to keep in mind that many accounting adjustments will be dependent on
assumptions and estimates

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Chapter 5: Financial Ratio Analysis

Financial Analysis: The application of analytical tools and techniques to general purpose
financial statements and data to derive some estimates and inferences in business analysis.
- To decrease uncertainty
- To decrease reliance on guesses and intuition

Ratio Analysis: Relate line items in financial statements to measure performance

Cash Flow Analysis: Assess the management of operating, investment and financing cash
flows and firms liquidity

Time series  compare over the years

Cross sectional  compare within the industry

Measuring overall Profitability

ROE = comprehensive measure of performance

Net profit
ROE=
Shareholdersequity

1. Traditional approach:
Net profit margin (profit/sales)
X Asset turnover (sales/total assets)
= Return on assets
X Equity multiplier (Total assets/shareholders equity)
= Return on equity

Net profit Sales Total assets

ROE= x x
Sales Total assets Shareholders equity

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Income Statement Items

Interest expense after tax Interest expense x (1 – tax rate)
Net investement profit after tax (NIPAT) (investment income + interest income) x (1-
tax rate)
Net operating profit after tax (NOPAT) Net profit – NIPAT + interest expense after
tax

Balance sheet Items

Operating working capital (current assets – excess cash and cash
equivalents) – (current liabilities – current
debt and current portion of non-current
debt)
Net non-current operating assets Non-current tangible and intangible assets
+ Derivates – deferred tax liability –
noninterest bearing non-current liabilities
Investment assets (minority equity investment + other non-
operating investments + excess cash and
equivalents
Net operating assets Operating working capital + Net non-
current operating assets
Business assets Investment assets + Net operating assets
Debt Total interest bearing non-current liabilities
+ current debt and current portion of non-
current debt
Capital Debt + Equity

Nopat +Nipat Business assets interest expenseafter tax Debt

ROE= x − x
Business Assets Equity Debt Equity

ROE=ROBA + ROBA−( IEAT

Debt )
x
Debt
Equity

NOPAT + NIPAT
ROBA=
Business assets

ROE=ROBA + Spread x Financial leverage

2. Alternative approach
Net operating profit margin (Operating profit/sales)

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X Operating Asset turnover (Sales/Operating assets)

= Return on Net Operating Assets
X (Net operating assets/ business assets)
+ Return on investment assets (investment income/investment assets)
X (investments assets/business assets)
= Return on business assets
Spread ((NOPAT + NIPAT)/BA – IEAT/ DEBT)
X Financial leverage (Debt/equity)
= Financial leverage gain
ROE = Return on business assets + financial leverage gain

Use after tax values

Evaluating Operating Management

- Are the company’s margins consistent with its stated competitive strategy?
- Are the company’s margins changing? Look at underlying business causes in
competitions
- Changes in input costs?  gross profit margin
- Is the company managing its overhead and administrative costs well?  Gross profit
margin

Sales−Cost of sales
Gross Profit Margin=
Sales

NOPAT
NOPAT margin=
Sales

EBITDA
EBITDA margin=
Sales

Evaluating Investment Management

- Asset turnover  firms invest in assets  (sales/total assets)
o Working capital management
o Management of non-current operating assets

Working capital management ratios:

operating working capital
Operating working capital ¿ sales ratio=
Verkauf

Sales
Operating working capital turnover=
Opearting working capital

Operating working capital turnover indicates how many euros of revenue a firm is able to
generate for each euro invested in operating working capital

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Sales
Trade receivables turnover=
Trade receivables

Cost of sales
Inventoriesturnover =
Inventories

Purchases
Trade payables turnover=
Trade payables

Trade receivables turnover, inventories turnover and trade payables turnover allow for
examination of how productive the three principal components of working capital are used.

Trade receivables
Days receivables=
Average revenue per day

Number of days a customer’s invoice is outstanding before it is paid

Inventories
Days Inventories=
Average cost of sales per day

Number of days company holds inventory before selling it

Trade payables
Days payables=
Average purchases per day

Number of days it takes to pay creditors

Cash conversion cycle = Days inventories + Days receivables – Days payables

- Number of days it takes to receive cash from customers after having paid suppliers.
- Negative is good because it doesn’t take a lot of days to receive cash from customers
after having paid suppliers

Non-current asset management

Non current operating assets are usually plant, property and equipment, intangible assets
such as goodwill and derivatives used to hedge operating risks. Non interest bearing non
current liabilities include items such as deferred taxes

Revenue
Net non−current operating asset turnover=
Net non−current operating assets

The efficiency with which a firm uses its net non-current operating assets

Revenue
PP∧E turnover=
Net property , plant ,∧equipment
The efficiency with which a firm’s PP& E is used

Evaluating Financial Management

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- Use of liabilities aimed at increasing firm performance at the cost of increasing

financial risk
o Liquidity analysis relates to evaluating the ability to repay current liabilities
o Solvency analysis relates to evaluating the ability to repay longer term
liabilities

Ratios measuring the firm’s ability to repay its current liabilities

Current assets
Current ratio=
Current liabilities

Cash∧cash equivalents+trade receivables

Quick ratio=
Current liabilities

Cash∧cash equivalents
Cashratio=
Current liabilities

Cash flow
Operating cash flow ratio=¿ operations ¿
Current liabilities

Evaluate firms mix of debt and equity:

Total liabilities
Liabilites ¿ equity ratio=
Shareholdersequity

Current debt+non current debt

Debt ¿ equity ratio=
Shareholders equity

Current debt+non current debt

Debt ¿ capital ratio=
current debt +non current debt+Shareholdersequity

The ease with which a firm can meet its interest payments is an indication of the degree of
risk associated with its debt policy

Profit+interest expense+tax expense

Interest coverage earnings basis=
interest expense

Profit+interest expense after tax

Interest coverage earnings basis=
interest expense after tax

cash flow
Interest coverage cash flow basis=¿ operations+interest paid+ taxes paid ¿
interest paid

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The debt coverage ratio measures a firm’s ability to measure all fixed financial obligations
such as interest payments, lease payments and debt repayments.

profit +interest ∧lease expense x ( 1−tax rate )

Debt coverage cash flow basis=
interest ∧lease expense x ( 1−tax rate )+debt repayments

Sustainable growth rate

Sustainable growthrate=ROE x (1−Dividend payout ratio)

cash dividends paid

Dividend payout ratio=
profit ∨loss

Sustainable growth rate is the rate at which a firm can grow while keeping its profitability
and financial policies unchanged.

Cash flow analysis

- Cash flow analysis provide further insights into operating, investing and financing
activities. All companies under IFRS are required to include a statement of cash flows
in their financial statements
o Direct  operating cash receipts are reported directly
o Indirect  details the accrual adjustments that need to be made to profit or
loss in order to arrive at operating cash flows.

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Chapter 6: Prospective Analysis, Forecasting

Prospective analysis includes two tasks: forecasting and valuation that together represent
approaches to explicitly summarizing the analyst’s forward-looking views.

Comprehensive forecasting approach: producing not only an earnings forecast but also a
forecast for cash flows and the balance sheet.

Projecting condensed financial statements  make assumptions of the ratios of chapter 5

- Income statement
- Balance sheet
- Cash flow statement

Performance behavior:
- Revenue growth behavior
o Mean reverting  firms with above average or below average rates of
revenue tend to revert over time to a normal level
- Earnings behavior
o Previous year is a good starting point in considering future earnings potential
o Random walk, long term trends tend to be sustained
- Returns on equity behavior
o Mean reverting
- Behavior of components of ROE
o Look at NOPAT margin, operating asset turnover, return on investment assets,
the proportion of capital invested in operating assets, spread and financial
leverage.
Information for forecasting:
1. Predict changes in environmental and firm specific factors
a. Industry growth
2. Assess the relationship between step 1 factors and financial performance
a. Sources of performance previous years
b. Permanent performance effects
c. Trend in financial performance
3. Forecast condensed financial statements
a. Sales
b. NOPAT
c. NIPAT
d. Interest expense after tax
e. Net profit
f. Net operating working capital
g. Net operating noncurrent assets
h. Investment assets
i. Debt to capital

Assumptions:
- Macroeconomic and industry growth
o Economic circumstances

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o Will slow growth in the industry motivate the company to intensify price
competition?
o Brand recognition
o Quality of reported items
o Misstated past earnings and assets
- Revenue growth
o Management’s outlook
o Foreign currency and exchange rates
o Changes in H&M store portfolio
o Changes in consumer demand
- Net operating profit after taxes margins
o Input prices
o Foreign currency and exchange rates
o Inventory markdowns
o SG&A costs
o Tax rate
- Working capital to revenue
- Non-current assets to revenue
- Non-operating investments
- Capital structure

Sensitivity analysis: Forecasts should be done with more than one possible set of
assumptions in mind. Each assumption should be tested to have results for the greatest
uncertainty.

Interim forecasts: the most recent quarter’s performance

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Chapter 7: Prospective Analysis, Valuation Theory and Concepts

Valuation: the process of converting a forecast estimate of the value of firm’s asset or equity

Four common methods:

- Discount dividends
- Discounted cash flows
- Abnormal earnings
- Abnormal earnings growth

1. Discount Dividends
- The present value of future cash flows to shareholders is the basis of the discounted
dividends method

e
1+r ¿
¿
¿2
¿
e ....
1+r ¿
¿
¿
Dividend 1 Dividend 2
Equity Value= +
1+ℜ ¿

If Constant growth rate

Dividend
Equity value=
ℜ−g
2. Discounted Cash Flow model
- The present value of free cash flows to equity shareholders is the basis of the
discounted cash flow model
- BVA = Book value assets
- BVD = Book value debt

FreeCash Flow=Profit −Change∈book value of net assets+ Change∈book value of debt

e
1+r ¿
¿
¿2
¿
e
.
1+r ¿
¿
¿3
¿
FCF 1 FCF 2
Equity Value= + ¿
1+ℜ

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Enterprise value = equity value + value of debt

3. The Discounted Abnormal Profit Model

- Abnormal earnings are those that differ from the expected return
- BVE = Book value equity

BVE 1=BVE 0+ profit −dividend

Dividend= profit + BVE 0−BVE 1

profit −ℜ∗BVE 0 profit−ℜ∗BVE 1

Equity=BVE 0+ +
1+ℜ ( 1+ ℜ )2

Winst boven re *BVE0  abnormal earnings, discount

4. The Discounted Abnormal Profit Growth Model

- Abnormal earnings growth is the annual change in abnormal earnings

Valuation Using Price Multiples

- Step 1: select a measure of performance or value
- Calculate the price multiples for comparable firms
- Apply the comparable firm multiple to the performance or value measure of the firm
being analyzed

e
1+r ¿
¿
¿2
¿
e
1+r ¿
¿
¿
ROE 1−ℜ ( ( ROE 2−ℜ ) (1+ g 1 equity ) )
Equity value ¿ book multiple=1+ +
1+ ℜ ¿

BVEt −BVE t −1
gtequity=
BVE t−1

Equity value=Initial Book value∗Equity value¿ b ook multiple

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Issues:
- selecting comparable firms
- multiples for firms with poor performance
- adjusting multiples for leverage

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Chapter 8: Prospective Analysis, Valuation Implementation

Key issues to implement valuation

1. Determining the discount rate
2. Making forecasts of financial performance
a. Detailed forecasts over a number of years
b. Arriving at a forecasted terminal value
3. Choosing equity valuation vs. asset valuation

Capital asset pricing model

ℜ=rf + B equity [ E ( rm ) −rf ]

Risk free rate = rate on intermediate term government bonds

Market risk premium: excess of the expected return on the market over the risk-free rate
Beta: historical association between firm specific and market returns

[
Bequity= 1+ ( 1−tax rate ) x
Debt
Equity ]
BBusiness assets

Adjusting for leverage and non-operating investments:

WACC – Weighted average cost of capital

- The appropriate discount rate to value a company’s assets is the WACC, which takes
into account debt and equity sources of financing

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Debt Equity
WACC= ( 1−tax rate ) x cost of debt + cost of equity
Debt + Equity Debt + Equity

Terminal Value: is the final year of the forecast and represents the present value of future
abnormal earnings or free cash flows for the remainder of the firm’s life.

( 1+ g )∗abnormal earnings
TV =
ℜ−g

(1+ g )∗abnormal earnings

ℜ−g
Discounted TV =
(1+ℜ )n

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Chapter 9: Equity Security Analysis

Security analysis: the evaluation of a firm and its prospects from the perspective of a
current or potential investor in the firm’s shares.

The process of gathering and organizing information and then using it to determine the
intrinsic value of a firm’s equity

Aim:
- Determining investment opportunities
o Establishing investment objectives
o Developing expectations about future returns and risks of individual securities
o Combining individual securities into portfolios that meet investment
objectives
- Projecting future returns and assessing risk
o Identification of mispriced stocks

Collective investment funds: funds that sell shares in professionally managed portfolios that
invest in specific types of equity and income securities

Efficient Markets Hypothesis: Posits that security prices reflect all available information fully
and immediately upon its release
- Perfectly efficient markets  impossible to identify mispriced stocks
- If markets are extremely efficient the few who receive newly announced financial
information could trade advantageously on it before it is fully disseminated to the
rest of the market

Importance of security analysis

- All of the people doing fundamental analysis is the reason the market is efficient
- Financial markets may not be perfectly efficient
- Pricing errors are inevitable

Security analysis – Traditional approach

- Step 1: economic analysis
- Step 2: industry analysis
- Step 3: fundamental analysis
o Financial condition
o Historical behavior

Security analysis – comprehensive approach

- Step 1: selection of candidates to analyze
o Specialization by industry sector or potential mispricing basis allows more
depth of analysis
- Step 2: inferring market expectations
o Identifying potentially mispriced securities requires a comparison of the
analysts’ expectations with those of the market

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- Step 3: developing analysts expectations

o Forecast of earnings and cash flows with an estimate of value must be derived
from the analyses performed
- Step 4: the final product of security analysis
o Financial analysts must ultimately recommend some action to take on a
security based on the analyses conducted

Intrinsic value > market value  buy

Intrinsic value < market value  sell
Intrinsic value approximates market value  hold or review

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Chapter 10: Credit Analysis and Distress Prediction

Credit Analysis: The evaluation of the risk of a firm in terms of repayment ability from the
perspective of a current or potential holder of its debt, trade payables, loans or any liability.
- Numerous parties are interested in creditworthiness of a company including banks,
investors, suppliers, auditors and employees
- Debt is an important source of financing though there are trade-offs in financing with
debt instead of equity capital

Why firms use debt financing

- Interest tax shield
o Deduct interest paid on debt as an ordinary business expense
- Management incentive alignment
o Imposes a discipline on management to create value reducing conflicts of
interests between managers and shareholders

Downsides:
- Higher likelihood of financial distress
o Legal costs
o Damage to ability to raise capital
o Costs of conflicts between creditors and stockholders
-

Country differences in debt financing

- Extent to which national bankruptcy laws protects debt providers
- Multiple bank borrowing
- Supplier financing
- Off balance sheet financing
- Public debt
- Borrower friendly and creditor unfriendly countries

The better the firms business prospects, the lower the risk to the creditor

Credit analysis process in private debt markets

- Consider the nature and purpose of the loan
o Terms, size and duration of the loan
- Consider the type of loan and available security
o Type and amount of security needed to collaterize the loan
- Conduct financial analysis
o Liquidity
o Solvency
- Assemble loan structure and debt covenants
o Maintenance ratio of minimum net worth
o Minimum coverage ratio
o Maximum ratio of total liabilities ot net worth
o Minimum net working capital balance to current raito

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o Maximum ratio of capital expenditures to earnings before depreciation

Financial statement analysis and public debt:

- Rating system from D to AAA that grades the relative riskiness of debt, debt ratings
influence the yield that debt instruments must pay for investors to buy them.
o AAA most profitable
o D indicates default
- Factors driving debt ratings
o Profitability measures  return on net capital
o Leverage measures
o Profitability and leverage
o Firm size
o Cash flow performance
o Riskiness of profit stream

Prediction of distress
- Altmans z score model, which weights five variables to compute a banktrupcy score
- X1 = net working capital/total assets  measure of liquidity
- X2 = retained earnings/total assets  measure of cumulative profitability
- X3 = EBIT/total assets  measure of return on assets
- X4 = market value of equity/book value of total liabilities  measure of market
leverage
- X5 = revenue/total assets  measure of revenue generating potential of assets

Z =1.2 X 1+1.4 X 2+3.3 X 3+0.6 X 4+1.0 X 5

When Z < 1.81, model predicts bankruptcy

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