TERM PROJECT CORE INSTRUCTIONS (Additional Information Posted Below the Instructions after the Rubric)

Deliverable: A project report not to exceed 3 pages in total. Please clearly type or mark your answers to avoid any ambiguity and to facilitate grading. Double check your answers!

1. Purpose: The purpose of this project is to provide hands-on opportunity to conduct a simple Credit Risk Analysis (covered in Unit 9, Week 3), using the Altman Z-Score model. Use the information provided in the Excel spreadsheet under the same folder as this handout (see also Week 3 Class Notes) to calculate the Altmans Z-Score of ELVA Product, Inc., and comment on your results.
2. Instructions:
3. Use Model 1 in the posted accompanying spreadsheet to predict the probability of financial distress and possibly bankruptcy for ELVA, assuming ELVA is a public company.
4. To decide whether ELVA will experience financial distress or not, refer to the proposed cutoff points, which are part of the models presented on page 1 of the spreadsheet. (Also see posted sample spreadsheet)
5. Based on the results you obtained, assign a likely Credit Rating, per Standard & Poors or Moodys classification, as discussed in the relevant class material or your own research. Please, provide complete and detailed reference(s) if you use your own researched material or additional sources for the analysis and assignment of a rating.
6. Note that the Altmans variable X1 involves Net Working Capital that equals Current Assets less Current Liabilities, which you should calculate from the balance sheet for each year. For variable X4, please use the Book Value of All Assets as a proxy for Market Value of All Assets.
7. The key information for solving this project is presented in the balance sheets and income statements of ELVA, which appear on page 3 of the Excel spreadsheet.
8. The customary financial ratios are presented on page 2 of the spreadsheet for your reference.
9. The Altmans Z-Score models, including the definition of the variables, is presented on the first page of the spreadsheet. Also, refer to read the article below for more details about the models.

Reference:

Altman, E. I., Predicting Financial Distress of Companies: Revisiting the Z-Score and ZETA Models (July 2000)

3. Assessment Rubrics:

MAX POINTS	CRITERIA
4 points	Adequate application of analytical skills and implementation of the correct model in the Excel Spreadsheet.
4 points	Correct interpretation of the variable and calculations. One (1) point will be deducted for each variable that is misinterpreted and incorrectly measured.
2 points	Adequate interpretation of the final findings and conclusion (correct numerical results and meaningful rating estimate).
10 POINTS	Potential maximum points to be earned for meeting or exceeding expectations.

PREDICTING A FIRM'S FINANCIAL DISTRESS

Altman's Z-Score Methodology

ALTMAN'S Z-Score Models for Predicting a Firms' Financial Distress

Model 1 (Original): For publicly-held companies

Z=1.2X1 +1.4X2+3.3X3 +0.6X4 +1X5

Z* = Cutoff point = 2.675

. If Z < 2.675 . If Z > 2.675

. If Z < 1.81

. If 1.81 < Z < 2.675 . If Z > 2.675

=> Firm can be reasonably be expected to experience severe financial distress, and possibly bankruptcy, within the next year.

=> No financial distress predicted.

=> Firm can be reasonably be expected to experience severe financial distress, and possibly bankruptcy, within one year.

=> Financial distress and possible bankruptcy. => No financial distress predicted.

Note: Model was found 80-90% accurate when using a cutoff point of 2.675

X1 = Net Working Capital/Total Assets X2 = Retained Earnings/Total Assets X3 = EBIT/Total Assets X4 = Market Value of All Assets/Book Value of Total Liabilities X5 = Sales/Total Assets

Model 2: For privately-held companies

Z' = 0.717X1 + 0.847X2 + 3.107X3 + 0.420X4 + 0.998X5

. If Z' < 1.21 . If 1.23 < Z' < 2.90 . If Z' > 2.90

X1 = Net Working Capital/Total Assets X2 = Retained Earnings/Total Assets X3 = EBIT/Total Assets X4 = Book Value of All Assets/Book Value of Total Liabilities X5 = Sales/Total Assets

=> Bankruptcy is predicted within one year => Financial distress, possible bankruptcy => No Financial distress predicted

Note: The predictive ability of the model was even better when using a cutoff point of 1.81.

References: 1) Altman, E. I., "Predicting Financial Distress of Companies: Revisiting the Z-Score and ZETA(R) Models" (July 2000) 2) Also see chap. 21 in Fabozzi, F. J., Bond Markets, Analysis and Strategies, 8e, for other and more sophisticated credit risk models.

Some Common Financial Ratios

1. Liquidity Ratios - measure the firm's ability to meet its current obligations

1.1 Current Ratio = Current Assets/Current Liabilities 1.2 Quick Ratio = (Current Assets - Inventories)/CL

2. Efficiency Ratios - asset management ratios; how well firm manages its assets

2.1 Inventory Turnover Ratio = Cost of Goods Sold (COGS)/Inventory or Sales/Inventory 2.2 Accounts Receivable Turnover Ratio = Credit Sales/Accounts Receivable 2.3 Average Collection Period = Accounts Receivable/(Annual Credit Sales/360) or you can use 365 2.4 Fixed Asset Turnover Ratio = Sales/Net Fixed Assets 2.5 Total Asset Turnover Ratio = Sales/Total Assets

3. Leverage Ratios or Debt management ratios: measure degree to which firm uses debt to finance assets

3.1 Total Debt Ratio = Total Debt/Total Assets = (Total Assets - Total Equity)/Total Assets 3.2 Long-Debt Ratio = Long-Term Debt/Total Assets 3.3 Long-Term Debt to Total Capitalization Ratio = LTD/(LTD + Preferred Equity + Common Equity) 3.4 Debt-to-Equity Ratio = Total Debt/Total Equity 3.5 Long-Term Debt to Equity Ratio = LTD/(Preferred Equity + Common Equity)

4. Coverage Ratios: measures firm's ability to pay certain expenses (eg. interest), similar to liquidity ratios

4.1 Times Interest Earned Ratio = EBIT/Interest Expense 4.2 Cash Coverage Ratio = (EBIT + Non-Cash Expenses)/Interest Expense

5. Profitability Ratios - measures how profitable a firm has been over a period of time

5.1 Gross Profit Margin = Gross Profit/Sales 5.2 Operating Profit Margin = Net Operating Income/Sales 5.3 Net Profit Margin = Net Income/Sales 5.4 ROA = Net Income/Total Assets 5.5 ROE = Net Income/Total Equity 5.6 Return on Common Equity = Net Income Available to Common/Common Equity 5.7 Du Pont System: ROE = PM x TAT x EM

REQUIRED TASK: Referring to the financial statements below, apply the Altman's Z-score model 1

to predict ELVA's likelihood of financial distress. Interpret your results, including a comment on the change between 2006 and 2007.

ELVA Products, Inc. Balance Sheet, As of December 31, 2007

Assets 2007 2006

Cash and Equivalents 52,000 57,600

Accounts Receivable 402,000 351,200

Inventory 836,000 715,200

Total Current Assets 1,290,000 1,124,000

Plant & Equipment 527,000 491,000

Accum. Depreciation 166,200 146,200

Total Assets 1,650,000 1,468,800

Liabilities and Owner's Equity

Accounts Payable 175,000 145,000

Short-term Notes Payable 225,000 200,000

Other Current Liabilities 140,000 136,000

Total Current Liabilities 540,200 481,600

Long-term Debt 424,612 323,432

Total Liabilities 954,812 805,032

Common Stock 460,000 460,000

Retained Earnings 225,988 203,768

Total Shareholder's Equity 685,988 663,768

Total Liabilities and Owner's Equity 1,650,000 1,468,800

ELVA Products, Inc. Income Statement, For the Year Ended December 31, 2007 ($ in 000's)

2007 2006

Sales 3,850.00 3,432.00

Cost of Goods Sold 3,250.00 2864.00

Gross Profit 600.00 568.00

Selling and G&A Expenses 330.30 240.00

Fixed Expenses 100.00 100.00

Depreciation Expense 20.00 18.90

EBIT 149.70 209.10

Interest Expense 76.00 62.50

Earnings Before Taxes 73.70 146.60

Taxes 29.48 58.64

Net Income 44.22 87.96

Notes: Tax Rate 40%

Z-Score Information:

The Z-score Formula Here is the formula (for manufacturing firms), which is built out of the five weighted financial ratios:

Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where: A = Working Capital/Total Assets B = Retained Earnings/Total Assets C = Earnings Before Interest & Tax/Total Assets D = Market Value of Equity/Total Liabilities E = Sales/Total Assets

Strictly speaking, the lower the score, the higher the odds are that a company is headed for bankruptcy. A Z-score of lower than 1.8, in particular, indicates that the company is heading for bankruptcy. Companies with scores above 3 are unlikely to enter bankruptcy. Scores in between 1.8 and 3 lie in a gray area.