Friday, February 6, 2009

Could You Have Seen Circuit City's Bankruptcy Coming?

A few months ago, Circuit City announced that it would seek bankruptcy protection, causing its share price to drop by over 75% in value. It was clearly getting beaten by Best Buy in most operational categories, and carried a more dangerous debt load. But on the other hand, it still had a very positive book value and its current assets appeared to more than meet its current liabilities. So how could one have seen this bankruptcy coming?

Unfortunately, determining whether a company is likely to go bankrupt is not an easy task. Research analysts spend weeks pouring over industry reports and considering macroeconomic, industry and company factors such as financial ratios and management capabilities.

Since the mid 1980s, a quantitative method that has gained acceptance in determining whether a firm will go bankrupt is the Z-Score, developed by a professor at NYU's business school. The Z-Score is found by weighing and then summing the following five factors:
  1. Working Capital / Total Assets
  2. Retained Earnings / Total Assets
  3. EBIT / Total Assets
  4. Market Value / Liabilities
  5. Sales / Total Assets
A score above 3 implies the company is fairly safe, while a score below 1.8 suggests big trouble ahead.

So how did Circuit City do on this scale prior to its bankruptcy announcement? It scored a healthy 3.86! While academic research has shown the Z-Score to be accurate about 70% of the time, it's obviously not perfect. While debt rating agencies also come up with formulas that help them determine the probability of default, qualitative information is also incorporated in these analyses, as the numbers by themselves are generally not considered enough to properly judge the probability of default.

Also, the Z-Score was meant to apply to public manufacturing companies. It has since been adapted in numerous ways in order to better fit data for other types of enterprises. Nevertheless, determining an impending bankruptcy is far from a perfect science: note that since Circuit City's stock dropped by such a large amount following the bankruptcy announcement, it did catch the market off-guard.

Interested in determining a company's Z-Score? You can use this site to input the data and it will complete the calculations for you.


Miguel Barbosa said...


Great post. Also, thank you for constantly delivering great content . I enjoy linking to your blog in my nightly investment links. Have a great weekend & take care.

Best Regards,

Miguel Barbosa
Founder of

Saj Karsan said...

I appreciate that, thanks Miguel!

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