Your Money: Could your bank be headed for bankruptcy?

Altman developed the Z score as a tool for predicting the bankruptcy of a bank.

Altman Z score is used to identify bankruptcy potential of firms. However, the initial model developed by Altman does not help in predicting bankruptcy of banks. For that, we need to use Altman’s customised model for banks.

Hypothetical illustration
Given, financial data (Rs crore) of Pranaya Piyush Bank (PP): Earnings Before Interest & Tax (EBIT) 5,000; total assets 50,000; working capital (10,000); retained earnings 7,000; revenue 10,000; book value of debt 30,000; market capitalisation 90,000.

Altman Z Score for banks
Altman developed the Z score as a tool for predicting the bankruptcy of a bank. Z score is computed as the sum of 6.56 (working capital/total assets) +3.26 (retained earnings/total assets) +6.72 (EBIT/total assets) +1.05 (market value of equity/book value of debt) + 3.26. Higher the score of a bank in these variables, the better is its safety margin for investors. If the Z score is less than 1.10, the bank is a bankruptcy candidate; if Z score is above 2.60, the bank is out of the bankruptcy risk; if Z score is between 1.10 and 2.60, the bank is in the gray zone and it is difficult to predict its bankruptcy possibility. Sales to total asset ratio used in the model for manufacturing firms is not considered in the model for banks. Further, 3.26 is added to adjust for emerging market banks.

Working capital/total assets
For PP, it is (0.20 times) (negative working capital of Rs 10,000 crore/total assets of Rs 50,000 crore). If its previous period ratio is (0.30) times, then it has improved its performance in the current year. The weighted score is -1.31. For banks, normally current liabilities exceed current assets. So they have negative working capital.

Retained earnings/total assets
For PP, it is 0.14 times (= retained earnings of Rs 7,000 crore/ total assets of Rs 50,000 crore). If its previous period ratio is 0.10 times, then the bank has improved its performance in the current year. The weighted score is 0.46 (= 3.26 * 0.14).

EBIT/total assets
For PP, it is 0.10 times (Rs 5,000 crore/ Rs 50,000 crore). If its previous period ratio is 0.20 times, then the bank has fallen in its performance in the current year. The weighted score is 0.67(= 6.72 * 0.10).

MV of equity/BV of debt
For PP, it is 3 times (market cap of Rs 90,000 crore/ BV of debt of Rs 30,000 crore). If its previous period ratio is 2.5 times, then the bank has improved its solvency position. The weighted score is 3.15.

The Z score of PP is 2.97 (without adding 3.26 for emerging markets) and 6.23 (with addition of 3.26) which indicates that it is a safer bank for investors. Though the coefficients may change if we run the model using current data, the inter and intra comparison of a bank in these four variables may offer more clarity on the financial performance of a bank.

The writer is associate professor of Finance at XLRI – Xavier School of Management, Jamshedpur