10.2  Going Concerns versus Distressed Firm

In Chapter 2 we introduced Altman’s Z-Score for assessing whether a stock is a going concern or a distressed stock.   This approach was adopted by Altman (1968) who developed what has become known as “Altman’s Z-Score.”  

Altman Z-Score

Z = 1.2R1 + 1.4R2 + 3.3R3 + 0.6*R4 + 0.999*R5

The accounting ratios are defined as follows:

R1 = Net working capital /Total assets

R2 = Retained Earnings/Total Assets

R3 = EBIT/Total Assets

R4 = Shareholders’ Equity/Total Liabilities or Market Value of Equity/Total Liabilities

R5 = Sales/Total Assets

Interpreting Altman’s Score:  The Buckets

Z > 2.99 is viewed as a going concern

2.7 < Z < 2.99 possible insolvency

1.8 < Z < 2.7 high probability of insolvency

Z < 1.8 very high probability

Of course this is not meant to be blindly applied without considering other factors.  For example, in Chapter 1, you were introduced to Item 1A (Risk Factors section) of the 10-K report.  This item should also be read carefully in conjunction with the Item 7: Management’s Discussion and Analysis (MD&A) and Forward Looking Statements; if the company has issued debt, then in this section of the form 10-K the company will provide information about its current bond rating. For example Target (TGT) is a typical example:

“Maintaining strong investment-grade debt ratings is a key part of our financing strategy. Our current debt ratings are as follows:”

Similarly, IBM as we saw in chapter 4 provided the following information their Item 7, 10-K:

For the case of a truly distressed stock such as GM (at the time of this writing), and trading under the ticker symbol MTLQQ), the 10-K discussion of debt ratings is much more extensive.  GM states:

GENERAL MOTORS CORPORATION AND SUBSIDIARIES

Status of Debt Ratings

Our fixed income securities are rated by four independent credit rating agencies: DBRS, Moody’s Investor Service, Fitch Ratings, and Standard & Poors. The ratings indicate the agencies’ assessment of a company’s ability to pay interest, distributions, dividends, and principal on these securities. Lower credit ratings generally represent higher borrowing costs and reduced access to capital markets for a company. Their ratings of us are based on information we provide as well as other sources. The agencies consider a number of factors when determining a rating including, but not limited to, cash flows, liquidity, profitability, business position and risk profile, ability to service debt, and the amount of debt as a component of total capitalization.

DBRS, Moody’s, Fitch, and S&P currently rate our credit at non-investment grade. The following table summarizes our credit ratings at February 27, 2009:

Rating actions taken by each of the credit rating agencies from January 1, 2008 through February 27, 2009 are as follows:

DBRS:

  •   June 20, 2008 — Affirmed our Corporate rating at B (high) and Senior Unsecured rating at B and placed the credit ratings Under Review with Negative Implications from Stable trend.

  •   August 18, 2008 — Downgraded our Corporate rating to B (low) from B (high), initiated coverage on our Secured rating at RR2/B (high), and confirmed our Senior Unsecured rating at RR4/CCC (high).

  •   November 7, 2008 — Downgraded our Corporate rating to CC from B (low), our Senior Unsecured rating to CC from CCC (high), and our Senior Secured rating to CCC (low) from B (high). The outlook is negative.

Fitch:

  •   February 27, 2008 — Affirmed our issuer-default rating at B with Negative outlook.

  •   June 25, 2008 — Downgraded our Corporate rating to B- from B, our Secured rating to

BB- from BB, and our Senior Unsecured rating to CCC+ from B- with Negative outlook.

  •   September 22, 2008 — Downgraded our Corporate rating to CCC from B-, our Senior Secured rating to B/RR1 from BB-/RR1, and our Senior Unsecured rating to CCC-/RR5 from CCC+/RR5.

  •   November 7, 2008 — Placed our rating on Credit Watch with negative implications.

  •   December 19, 2008 — Downgraded our Corporate rating to C from CCC, our Senior Secured rating to CCC/RR1 from B/RR1, and our Senior Unsecured rating to C/RR5 from CCC-/RR5. The outlook is negative.

Moody’s:

  •   April 25, 2008 — Affirmed our Corporate debt rating at B3 and placed the credit rating on Negative outlook from Stable outlook.

  •   July 15, 2008 — Affirmed our Corporate debt rating at B3 and placed the credit rating Under Review for Possible Downgrade from Negative outlook. Speculative Grade Liquidity rating was lowered to SGL-2 from SGL-1.

  •   August 13, 2008 — Downgraded our Corporate ratings to Caa1 from B3, our Senior Secured rating to B1 from Ba3, and our Senior Unsecured to Caa2 from Caa1.

  •   October 27, 2008 — Downgraded our Corporate rating to Caa2 from Caa1, our Senior Unsecured rating to Caa3 from Caa2, and our Senior Secured rating remained at B1. Our Speculative Grade Liquidity rating was lowered to SGL-4 from SGL-2.

 •   December 3, 2008 — Downgraded our Corporate rating to Ca from Caa2, our Senior Unsecured rating to C from Caa3, and our Senior Secured rating to B3 from B1. Our Speculative Grade Liquidity rating was reaffirmed at SGL-4. The outlook is negative.

S&P:

  •   March 17, 2008 — Affirmed our Corporate debt rating at B and placed the credit rating on Credit Watch with Negative Implications from Stable outlook.

  •   May 22, 2008 — Affirmed our Corporate rating at B, upgraded our Senior Unsecured rating to B from B- as a result of extending its recovery ratings to all speculative-grade unsecured debt issues, and placed the credit ratings of Negative outlook from Credit Watch with Negative Implications.

  •   June 20, 2008 — Affirmed our B Corporate rating and BB- Secured rating and placed the credit ratings on Credit Watch with Negative Implications from Negative outlook.

  •   July 31, 2008 — Downgraded our Corporate rating to B- from B, Senior Secured rating to B+ from BB-, Senior Unsecured rating to B- from B with Negative outlook.

  •   October 9, 2008 — Placed our ratings under Credit Watch with negative implications.

  •   November 7, 2008 — Downgraded our Corporate rating and Senior Unsecured rating to CCC+ from B- and our Senior Secured rating to B from B+ with Negative outlook.

  •   December 4, 2008 — Downgraded our Corporate rating and Senior Unsecured rating to CC from CCC+ and our Senior Secured rating to CCC from B.

  •   December 22, 2008 — Downgraded our Senior Unsecured rating to C from CC and our recovery rating to 6 from 4, and our Corporate rating and Senior Secured rating remained unchanged. The outlook is negative.

The ratings referred to in the report are interpreted as follows:

 

The prospect of not being a going concern increases once a firm falls out of the investment grade category.  We know that default rates rise above 1% and substantially above 1% if firms are rated C or below.  The credit ratings for IBM and Target would imply around 0.1 of 1% chance of defaulting.  This makes the going concern assumption very reasonable for these companies.   GM on the other hand is a distressed stock and has a negative stockholder’s equity at the time of this writing.    Even as early as 2005, various reports (available on the internet, just enter “GM Z-score” into your search engine) showed GM’s Z-score as being in significantly less that 1; a calculation by Altman (the creator of the Z-score) had it at 0.55, which indicates a very high probability of bankruptcy, and a negative Z-score of -0.17 as of September 2008.