Many are familiar with Edward Altman’s Z-Score which can be used to predict the likelihood of a company entering bankruptcy. While it is an empirical measure and not like the theory-backed tools we usually use, it is part of the analysis of almost all companies we work with. Our anecdotal accuracy matches Professor Altman’s findings.
The inputs to the Z-Score are internal to the business being evaluated. While many in the turnaround management industry estimate that 79% of business failures are because of internal reasons, 21% are because of external reasons. In today’s environment the external reasons could become more pronounced so we should be aware of them even more.
As Warren Buffet famously said, “you only find out who is swimming naked when the tide goes out.”
In his seminal turnaround management book Corporate Turnaround, Donald Bibeault brings to the toolbox one of Professor Altman’s lesser known works which includes the effect of macroeconomic factors on business failure rates. He used “techniques of multiple regression to develop an equation for predicting the change in the number of failed businesses given changes in various economic indicators. After much analysis he was able to come up with the following reliable equation linking failure rates with GNP, (a) stock market index, and the money supply:”
FR = 1.54 – 0.222GNP – 1.90 SP + 0.495MS + e
FR is the change in failure rate (Dun and Bradstreet) from one quarter to the next
GNP is the change in GNP in billions of dollars between those quarters
SP in the change in the Standard and Poor Index of Common Stock Prices
MS is the change in the money supply in billions of dollars
While GNP data for Q2 is not yet out, according to the Federal Reserve Bank of St. Louis the money supply (M2) increased by 1.7 trillion in Q2. This makes the third portion of Altman’s regression quite large.
So what is a business owner or manager to do with this information? No matter how many business failures there are, not all businesses will fail. More likely, we will see a large wealth transfer in which new players step onto the stage and inefficient legacy organizations disappear. As Warren Buffet famously said, “you only find out who is swimming naked when the tide goes out.” It is now more critical than ever to get our suits on. The top two or three competitors in each industry rarely go bankrupt. It is the less efficient competitors that get exposed (often by being over-levered) or swept out with the tide.
Most business failures will still be for internal reasons, so while we must always be aware of the macro market in which we operate, the most telling signs can come from someone giving us a candid internal assessment that we may not be able to see. More than ever it is critical for each business to identify and defend it niche, execute on business models that aren't working capital intensive, and create a more compelling value for its customers.