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Coefficient of bankrupcy
The coefficient of bankruptcy is calculated based on five elements: the ratio of working capital and total assets (X1), the ratio of retained earnings and total assets (X2), a ratio of EBIT (Earnings Before Interest and Taxes) and total assets (X3), the ratio of market value and debt ( X4) and the ratio of income and total assets (X5).
X1 - the ratio of working capital and total assets introduces the impact of liquidity on the business. Companies with low working capital and therefore with negative value of X1, will probably have problems with fulfilling short-term obligations. The reason for this is low value of short-therm assets that could cover them. On the other hand, companies whose working capital is positive will cover short-term obligations without any problems.
X2 - ratio of retained earnings and total assets. A low value indicates a policy of financing business by borrowing money, not with their own funding. The high value suggests the profitability of the business and the ability to overcome the adverse circumstances.
X3 - ratio of EBIT and total assets shows the ability of company to make profit from its assets.
X4 - the ratio of market value and debth. Higher value indicates that there is investor confidence in the success of company business, while a low value indicates the absence of confidence and the expectation of weak results.
X5 - the ratio of income and total assets is used for evaluation of management skills. A low value indicates that the market value of company stagnates or worse, declines.
The coefficient of bankruptcy is calculated by the formula:
1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + X5
The coefficient of bankruptcy is also called z-score. It is one of the most famous synthetic indicators. Value of more than three indicates that the company is financially stable, values between 1.8 i 3 are the so-called gray zone, while values below 1.8 indicate that the company have financial problems and possible bankruptcy.
It should be noted that this indicator cannot be aplied on companies that were recently created and have no earnings.