Corporate Governance and Financial Health
Three years ago I did some work for an independent credit rating agency utilizing a quantitative methodology to determine financial health of corporations. Dr. Patrick Caragata founder of the firm conducted a study of 200 TSX listed firms with high CGI ratings (Governance Metrics International). Dr. Caragata was seeking to determine the correlation of Corporate Governance (CG) and financial health. His findings revealed that “CG ratings failed to indicate when a company was in poor health 75% of the time. In fact, they wrongly identified 32% of weak companies as being highly rated on GMI.”
Dr. Caragata also extended his model to use financial health score as an early warning signal for a listed company’s share price. KMV, established ratings agencies, Altman’s Z Score were also determined as lagging predictors of share price. Dr. Caragata’s research on bond pricing and CDS where better predictors of financial health momentum and ultimate predictors of share price but still failed to correlate financial health score as an early warning signal for share prices. The problem that the model continually encountered was that valuation always exhibited a bias towards share price (market momentum) not financial health score. The determination of a “fair value” based on historical spreads of financial health score and share price was overly and overtly price sensitive. Perhaps a signal of an inefficient market? This was particularly true for bubble stock anomalies and commodity sensitive equities.
Purveyors of Business Process Management (BPM) suggest that listed practitioner’s of BPM trade at a 15% premium to non-practitioners. I wonder if its marketing boast. Though BPM is not CG; it does speak to having CG excellence in the corporate DNA. A cultural commitment to sound practices create valuation premiums and sustainable business models. That’s the message well managed companies consistently deliver as a central theme of their value proposition. Integrating sound practices and CG excellence into the corporate culture does create valuation premiums because it suggests an intentionality of business process deeply wedded to the enterprise mission.
I believe the radical reconfiguration of Wall Street offers a telling example of incongruity of good CG practitioners and financial health. It was always a self evident truth that Wall Street firms that folded or transformed into commercial banks were probably some of the best rated CG enterprises. CG excellence can do nothing to save an enterprise with a structurally flawed business model. Though CG excellence does presuppose a board of directors in tune with the vicissitudes of the market; who would have thought that we would be looking at the extinction of the global investment banking business? Merrill Lynch, Morgan Stanley, Lehman Brothers, Bear Stearns and the mighty Goldman Sachs were walking dinosaurs with flawed unsustainable business models? All either folded, were acquired or became FDIC insured commercial banks. I still can’t believe it but it’s true. The world is being turned upside down.
Sum2 is a firm believer in coupling quantitative and qualitative risk measures to maintain operational excellence to build a healthy sustainable enterprise. Effective CG alone cannot assure financial health. It must be a critical pillar of the governance, risk and compliance (GRC) triad.
When we speak about the principles of good governance, how about the original dissertation on the ideal of governance excellence. Seemingly an insistence on an honest evaluation of reality to determine what is good is all it takes. Its really that simple.
Visit the blog Risk Rap and the Allegory of the Cave post on FAS 157:
Sum2 welcomes the opportunity to speak with partners who share our passion for GRC excellence.
originally published 6/12/13
Measuring SME Credit Risk
The underlying financial health of Small Mid-Size Enterprises (SME) has always been difficult to determine, hard to identify and its never been more important.
To manage risk in the credit and capital markets it is critical for lenders and credit suppliers to understand the relative financial health of counter-parties, customers and suppliers. Effective credit extension decisions cannot be made without superior analysis generated by forward-looking, unbiased tools.
The credit crisis and recession has devastated small and mid-sized businesses. Getting a bank loan or securing capital from investors is a big challenge for small businesses. Banks have become extremely cautious in lending to small businesses. To be successful in securing credit you’ll have to demonstrate that you are a good credit risk, that your company’s prospects for growth are strong and that your business model is sound.
Why Credit Score is important?The quality of your credit rating and financial health form the basis for decisions other businesses make about you. Managing your business to improve your Credit Score will improve your company’s financial health. A strong Credit Score indicates good financial health and is used by lenders, capital providers, customers and suppliers to determine:
- How much business credit a supplier will extend to you
- What interest rates you will pay
- How much money lending institutions will loan you
- How your customers view you
- What your insurance premiums will be
- The level of potential investor interest
Sum2 utilizes Altman’s Z Score method to determine fundamental financial health ratings. The Z Score credit rating is valid measure of financial health for any public or privately held corporation. The Z Score rating methodology is a proven credit risk indicator that is widely used by banks, investment managers, Fortune 1000 companies and small to medium sized enterprises to determine and manage risk. Sum2’s clients use the Z Score rating products to determine financial health, remain in compliance with loan covenants, and assess credit worthiness of clients and mission critical suppliers.
Altman’s Z score method examines fundamental financial data derived from a company’s balance sheet and income statements. A credit rating is generated by the use of ratio analysis that yields valid comparative results regardless of the currency utilized. Working capital, earnings, reinvested earnings and leverage are integrated into a composite credit rating score. The components and standards are similar to those used by traditional lenders. It is an easily understood approach that provides comprehensive financial details not available with the standard agency reports.
Click here to access Sum2’s Z Score Input Template.
Click here to access zip file of sample reports. Palm Corp Z Score Report.
We recommend supplementing the analysis with trade reports from firms like the Credit Management Association (CMA) or Experian and others for their pertinent data and services.Businesses that extend credit can determine cutoff scores needed to qualify for credit as their risk tolerance and economic conditions change. Lower scores and classifications indicate higher probabilities of default.
Credit ratings must include a careful analysis of the income statement, balance sheet, changes in financial position and key metrics along with consideration of trends, economic conditions and other available data.
Credit|Redi is a set of business assessment tools that helps businesses determine credit worthiness. It is a critical business tool SME’s need to incorporate to better manage and assess credit risk.
More information on how to manage credit risk can be found here: Credit|Redi
Using the Z Score to Manage Corporate Financial Health
We use Altman’s Z Score as our measurement tool to assess a company’s financial condition. It incorporates fundamental financial analysis, offers a consistent measurement methodology across all business segments, and an enhanced level of transparency by use of fully disclosed and open calculation model.
Z Score Advantages
The Z Score provides a quantitative measurement into a company’s financial health. The Z Score highlights factors contributing to a company’s financial health and uncovers emerging trends that indicate improvements or deterioration in financial condition.
The Z Score is a critical tool business managers use to assess financial health. It helps managers align business strategies with capital allocation decisions and provide transparency of financial condition to lenders and equity capital providers. Business managers use the Z Score to raise capital and secure credit. The Z Score is an effective tool to demonstrate credit worthiness to bankers and soundness of business model to investors.
The Z Score is based on actual financial information derived from the operating performance of the business enterprise. It avoids biases of subjective assessments, conflicts of interest, brand and large company bias. The Z Score employs no theoretical assumptions or market inputs external to the company’s financial statements. This provides users of the Z Score with a consistent view and understanding of a company’s true financial health.
Background
The Z Score was first developed by NYU Professor Edward Altman. The Z Score methodology was developed to provide a more effective financial assessment tool for credit risk analysts and lenders. It is employed by credit professionals to mitigate risk in debt portfolios and by lenders to extend loans. It is widely utilized because it uses multiple variables to measure the financial health and credit worthiness of a borrower. The Z Score is an open system. This allows users of the Z Score to understand the variables employed in the algorithm. All the mysteries and added cost of “proprietary black box” systems are avoided empowering users to enjoy the benefits of a proven credit decision tool based solely on solid financial analysis.
The Z Score is also an effective tool to analyze the financial health and credit worthiness of private companies. It has gained wide acceptance from auditors, management accountants, courts, and database systems used for loan evaluation. The formula’s approach has been used in a variety of contexts and countries. Forty years of public scrutiny speaks highly of its validity.
Z Score Formula
The Z Score method examines liquidity, profitability, reinvested earnings and leverage which are integrated into a single composite score. It can be used with past, current or projected data as it requires no external inputs such as GDP or Market Price.
The Z Score uses a series of data points from a company’s balance sheet. It uses the data points to create and score ratios. These ratios are weighted and aggregated to compile a Z Score.
Z Score = 3.25 + 6.56(X1) + 3.26(X2) + 6.72(X3) + 1.05(X4) where
X1 = Working Capital / Total Assets
X2 = Retained Earnings / Total Assets
X3 = Earnings Before Interest & Tax / Total Assets
X4 = Total Book Equity /Total Liabilities
If you divide 1 by X4 then add 1 the result is the company’s total leverage.
The higher the score the more financially sound the company.
Z Score Ratings cutoff scores used in classifications:
AAA 8.15 AA 7.30
A 6.65 BBB 5.85
BB 4.95 B 4.15
CCC 3.20 D 3.19
Credit Worthiness and Cost Of Capital
Lenders and credit analysts use Z Scores because they are effective indicators and predictors of loan defaults. it is an important risk mitigation tool and helps them to better price credit products based on borrowers credit worthiness.
Utilizing a 10 year corporate mortality table demonstrates how Z Score ratings correlate to defaults. Those with a rating of A or better have a 10 year failure rate that ranges from .03% to .082%. The failure rate for those with a BBB rating jumps to 9.63%. BB, B and CCC failure rates are 19.69%, 37.26% and 58.63% respectively. These tables will differ slightly as each producer uses different criteria but overall they are quite similar.
Borrowers with higher Z Scores ratings will have a better chance of obtaining financing and secure a lower cost of capital and preferred interest rates because lenders will have greater confidence in being paid back their principal and interest. Financial wellness is an indication of strong company management and that effective governance controls are in place.
Managing Business Decisions to Improve Financial Health
The Z Score is also a critical business tool managers utilize to make informed business decisions to improve the financial health of the business. The Z Score helps managers assess the factors contributing to poor financial health. Z Score factors that contribute to under-performance; working capital, earnings retention, profitability and leverage can be isolated. This enables managers to initiate actions to improve the score of these factors contributing to financial distress. Targeting actions to specific under-performing stress factors allows managers to make capital allocation decisions that mitigate principal risk factors and produce optimal returns.
Focus areas for managers to improve Z Score are transactions that effect earnings/(losses), capital expenditures, equity and debt transactions.
The most common transactions include:
- Earnings (Net Earnings) increases working capital and equity.
- Adjust EBIT by adding back interest expense.
- Adjust EBIT by adding back income tax expense.
- Depreciation and amortization expense is already included in the earnings number so it won’t have an additional effect on earnings or equity but it will increase working capital as noncash items previously deducted.
- Capital Expenditures (fixed asset purchases) decrease working capital as cash is used to pay for them (whether the source is existing cash or new cash acquired from debt).
- Short term debt transactions have no effect on working capital as there are offsetting changes in both current assets and liabilities but does change total liabilities and total assets.
- Acquiring new long term debt increases working capital, total liabilities and total assets.
- Typical equity transactions (other than earnings, which we have already accounted for) are dividends paid to stockholders resulting in decreases to working capital and equity.
- New contributed capital increases working capital and equity.
Scenario Analysis
Using the Z Score financial managers can actively manage their balance sheet by considering transactions and initiatives designed to impact financial wellness. Considerable attention needs to be placed on how losses, sale of fixed assets and long term debt payments effect financial condition.
In the above we included the basic transactions that would likely occur but you can do the same for any scenario by applying the same concept. It may take a little practice to think in these groupings but you’ll shortly find yourself with the ability to project any event. The effects can be measured and revised as necessary by adjusting the contemplated transactions. Remember that several variables exist and that a combination of choices might be necessary to keep your financial strength at the desired level.
Any projection should include the calculation and comparison of key metrics to historical results to ensure that assumptions have been correctly calculated. Significant deviations from prior results should have adequate explanations. Maintaining a strong working capital position can offset the negative effects from increased debt, increased assets and minor earning declines.
Sum2′s Profit|Optimizer
Sum2 publishes the Profit|Optimizer. The Profit|Optimizer is a risk assessment and opportunity discovery tool for small and mid-sized businesses. It assists managers to identify and manage risk factors confronting their business. The goal of the Profit|Optimizer is to help business mangers demonstrate creditworthiness to lenders and make make informed capital allocation decisions.
Sum2 boasts a worldwide clientele of small and mid-sized business managers, bankers, CPA’s and risk management consultants that utilize the Profit|Optimizer to help their clients raise capital with effective risk governance.
Cautions
Financial models are not infallible and should be used in conjunction with common sense and with an awareness of market conditions. It is important to understand your model so that other considerations can be incorporated when necessary. Note that most models (Z score included) use a proxy (working capital) for liquidity which works well until there are severe disruptions in credit markets as recently encountered. Use caution with all models. Use extreme caution when using a proprietary black box system where you can’t understand all the components. Are these users aware or ignorant of possible issues?
Trust but verify seems like a prudent policy.
Conclusions
The Z Score is a valuable management tool to proactively assess the financial condition of the company’s balance sheet, uncover factors that are stressing the balance sheet and initiate actions to improve the financial wellness and credit worthiness of the firm. All business decisions and actions are ultimately revealed in the company’s balance sheet. The Z Score measures the effectiveness of business decisions. It empowers managers to anticipate changes occurring in credit worthiness and proactively manage changes in financial condition.
Armed with a tool to calculate future financial positions managers have the latitude to better manage outstanding receivables, improve liquidity and lower their cost of capital. Calls for capital, negotiations for funding or decisions in setting credit policy can now be made from a knowledgeable position with a set of supporting facts.
The Z Score gives business managers an important negotiating tool to defend their credit rating during capital raises when excess leverage or deficient levels of working capital and equity are present.
This post was authored by CreditAides.
This post was edited by Sum2llc
Risk: small business lending, credit risk, commercial lending, SME
Sum2 Announces Business Alliance with CreditAides
Sum2, LLC is pleased to announce that they will begin to offer the corporate rating products of CreditAides. CreditAides is an independent corporate rating and research firm that provides financial health assessment reports and credit risk analysis ratings on companies using the Z-Score methodology. The CreditAides reporting system is a predictive tool that helps managers gain insights into the financial health of a company. The insights help managers identify a company’s ability to remain competitive and financially sound while measuring the impact of business initiatives to achieve profitability and growth.
James McCallum, the President of Sum2 stated, “The CreditAides quantitative assessment tool is a wonderful compliment to the qualitative risk assessment applications offered in the Profit|Optimizer. Now our clients have a recognized standard to measure the financial impact and returns on capital allocation decisions they implemented as a result of a Profit|Optimizer review. The challenging business cycle requires that managers allocate capital to a few select initiatives. It is critical that managers fund initiatives that mitigate the greatest risk and provide the potential of optimal returns. The combination of CreditAides reports with the Profit|Optimizer will provide our clients with the ability to discern the optimal initiatives to fund and measure the effectiveness of their capital allocation decisions.”
The Profit|Optimizer guides business managers through an thorough enterprise risk assessment. Uncovering the risks and opportunities associated with products and markets, business functions, numerous macro risks and critical success factors are key components of effective enterprise risk management (ERM). ERM requires the assessment and aggregation of hundreds of risk factors. The Profit|Optimizer helps managers identify the key initiatives that will help to maintain profitability and sustainable growth. The use of CreditAides provides an important measurement tool to affirm and validate that managers have made correct bets on capital allocation decisions.
Z-Score Financial Analysis Tool
The Z-Score formula for predicting bankruptcy was developed by Edward I. Altman a Professor of Finance at New York University. The Z-Score is used to assess the financial health of companies and the probability of bankruptcy. The Z-score uses multiple corporate income and balance sheet values to score the financial health of a company. The use of Z-scores is a strategic tool managers use to measure and validate the effectiveness of their business strategy.
Risk Assessment and Opportunity Discovery
The recession has created macroeconomic conditions that are causing widespread business failures. Small and mid-size business enterprises (SME) require effective risk management tools to effectively manage business threats to survive extreme business downturns. Assessing, measuring, aggregating, prioritizing, pricing and initiating actions are the tactical means risk managers use to support the business objectives of the enterprise. Sound risk management practices are central to a healthy corporate governance culture and are central to maintaining profitability and long term sustainable growth for the business enterprise.
The Profit|Optimizer
Profit|Optimizer helps managers assess risk factors and uncover opportunities that are always present in the business environment. The product is based on Basel II working group recommendations that outline optimal risk profiles of SMEs. The Profit|Optimizer incorporates four focus areas.
1.) product and market dynamics (products, clients, competition, supply chain, market segments)
2.) business functions (management, sales and marketing, operations, facilities, IT, HR, accounting)
3.) critical success factors (generic and specific)
4.) macro risk factors (macroeconomic, STEEPLE, SWOT, segment benchmarks, business plan optimization)
SME’s lack of agility and reluctance to change has made it difficult for these businesses to survive severe market conditions. There are tremendous market forces at work in the current business environment that are creating dangers and opportunities for SMEs if they can effectively assess and adapt. Business managers must be astute and exacting how they allocate the precious capital resources required to achieve business objectives. The Profit|Optimizer helps managers make better capital allocation decisions. CreditAides provides fiscal metrics to validate or adjust business strategy and initiatives. Sum2’s risk assessment products coupled with the measurement tools provided by CreditAides creates a leading edge solution for SME risk management. The ease of use and superior value proposition of the combined solution is unsurpassed in the market.
About CreditAides
CreditAides (www.creditaides.com) online business analysis and credit assessment portal provides business managers with important insights into the financial health of their company. Automated financial analysis improves efficiency of the business enterprise. CreditAides reports are used to assess the financial health of clients, supply chain and used to demonstrate financial health and credit worthiness to credit and equity providers.
True underlying financial health of companies has never been harder to identify and never been of greater importance. Across both equity and credit markets, understanding relative financial strengths of companies is paramount for effective business decisions. Good decisions cannot be made without good quality information generated by incisive tools.
About Sum2, LLC
Sum2 (www.sum2.com) was founded in 2002 to promote the commercial application of corporate sound practices. Sum2 manufactures, aggregates, packages and distributes innovative sound practice digital content products to select channels and market segments. Sum2’s sound practice products address risk management, corporate governance, shareholder communications and regulatory compliance. Sum2’s objective is to assist businesses and industries to implement sound practices to create value for company stakeholders and demonstrate corporate governance excellence to assure profitability and long term sustainable growth.
You Tube Video: Ella Fitzgerald, A-Tisket A-Tasket
Risk: bankruptcy, default, market, credit
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