Sunday, April 23, 2017 2:59:46 PM
Intuition would suggest that market cap would not be particularly relevant. But The work of Edward Altman shows that one of the five factors in his linear discriminant model does consider the market value of equity ( numerator in X4)
There is a body of research on predicting corporate failure
he original Z-score formula was as follows:[1]
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5.
X1 = working capital / total assets. Measures liquid assets in relation to the size of the company.
X2 = retained earnings / total assets. Measures profitability that reflects the company's age and earning power.
X3 = earnings before interest and taxes / total assets. Measures operating efficiency apart from tax and leveraging factors. It recognizes operating earnings as being important to long-term viability.
X4 = market value of equity / book value of total liabilities. Adds market dimension that can show up security price fluctuation as a possible red flag.
X5 = sales / total assets. Standard measure for total asset turnover (varies greatly from industry to industry).
Altman found that the ratio profile for the bankrupt group fell at -0.25 avg, and for the non-bankrupt group at +4.48 avg.
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