Sizing up the coming surge of financial distress

If people with preexisting medical conditions have increased risk of severe illness from COVID-19, companies with weak balance sheets also have a higher risk of financial vulnerabilities from the COVID-19 crisis.

In 1968, a professor from New York University by the name of Edward Altman claimed that one can predict the risk of a company’s financial distress simply by following a scoring model.

Known as the Altman Z-score, this model, which computes a series of ratios from a company’s financial statements, generates a score that indicates how likely a company will fail in the near future.

According to Altman, companies with scores of less than 1.80 are considered financially problematic. The lower the resulting score, the higher the probability that the company will go bankrupt.

The formula for the Z-score, which uses five key financial ratios, is expressed as Z = 1.2a + 1.4b + 3.3c + 0.6d + 0.99e, where: The “a” in the formula represents the ratio of working capital divided by total assets; “b” is retained earnings divided by total assets; “c” is earnings before interest and tax divided by total assets; “d” is market capitalization divided by total liabilities; and “e” is revenues divided by total assets.

A low working capital as a percentage of total assets means that a company may be experiencing cash flow problems due to slower cash collections and inventory turnover.

A low retained earnings-to-total assets ratio means that a company may be accumulating losses from the business, while a low earnings- before-interest and tax-to-total assets ratio may indicate low returns on capital expenditures.

Such low returns can be confirmed with a low revenue-to-total assets ratio, which shows that a company may not be generating enough sales to justify its investments.

On the other hand, a company with low market cap-to-total liabilities ratio may mean that it has a higher risk of insolvency, resulting from higher financial leverage.

If we will use this model to detect the risk of financial distress in the Philippine Stock Exchange (PSE), we can find that the number of problema­tic companies with scores lower than 1.81 has been increasing over the years.

For example, in 2017, the percentage of financially distressed companies in the PSE was only 43.6 percent while the median Z-score was safe at 2.26, but in 2018, this percentage increased to 46.4 percent as median Z-score fell to 1.97.

By 2019, the percentage further increased to 47 percent with the median Z-score shrinking lower to 1.95, as more listed companies failed to pass the Altman test.

This year, with the outbreak of coronavirus pandemic, the percentage of listed companies in the PSE that are likely to get into serious financial troubles has gone up to 58 percent with the median Z-score falling to a record low to 1.33.

This seemingly emerging crisis is different from what we had in 2007 global financial crisis, because during that time, the percentage of companies with low Z-scores was only 33.8 percent, and when the crisis finally ended in 2009, the percentage increased only up to 49 percent with median Z-score of 1.82.

One reason why the Z-score did not fall below the 1.81 cut off during the 2007 crisis was because financial risk then was relatively low.

The ratio of total debt of PSE = listed companies to total market cap was only 12 percent in 2007, and when the market bottomed out in 2009, the ratio only increased up to 24.4 percent.

The situation today is significantly different. The huge build up of debt in the past decade caused by falling interest rates has increased financial risks to unprecedented levels.

For example, the ratio of total debt-to-total market cap in the PSE was only 34.7 percent in 2017, but by end of 2019, in just two years, this ratio has already increased to 50.2 percent.

The fall in the PSE index this year has further raised financial risks in the market, as the total debt-to-market cap ratio accelerated to a high of 63.7 percent.

Rising risk of business failures as suggested by falling Z-scores only shows that the stock market is headed for a lot more pain in the months ahead.

Henry Ong is a Registered Financial Planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend 86th batch of RFP Program this October 2020. To register, email or text at 09176248110.