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Chapter 8

Financial Tools and Techniques

There are a number of tools and techniques that can be used to gain an understanding of the debtor’s
condition at the valuation date and assess the appropriate premise of value in the context of a bankrupt-
cy. Examples include ratio and benchmark analysis (including an analysis of bankruptcy risk models),
an in-depth understanding of the statement of cash flows, an understanding of the debtor and its envi-
ronment (including SWOT [strengths, weaknesses, opportunities, threats] and competitive advantage as-
sessments), and general indications of distress.

Ratio and Benchmark Analysis

Operating ratios, financial ratios, performance indicators, and benchmarks can be used to measure im-
portant company attributes such as liquidity, profitability, leverage, and growth. As such, they can be
used to highlight trends and allow for comparisons with industry peers. Information on industry peers
can be obtained from sources such as RMA Annual Statement Studies, Integra’s 5-Year Industry Re-
ports, Dun and Bradstreet’s Industry Norms and Key Business Ratios, and CCH’s Almanac of Business
and Industrial Financial Ratios. If available, debtor ratios can also be compared to ratios of publicly
traded companies determined to be reasonably comparable to the debtor.

The results of these analyses and comparisons can lead to the identification of required normalization
adjustments, key value drivers, risk indicators, growth rates, and other important measures. Because they
can also be used to help detect operating and financial difficulties, analysts often use them for this pur-
pose.

Engagements involving bankruptcy and distressed situations will often call for extensive financial and
ratio analysis to be performed as part of the engagement. A detailed discussion of ratio and benchmark
analysis is beyond the scope of this practice aid.

Bankruptcy Risk Models

One of the first models developed to recognize patterns in a company’s historical financial statements
that could predict future bankruptcy was the Altman Z-Score model. fn 1 The first Z-Score model was
published by Dr. Edward I. Altman in 1968. This model uses several ratios from a company’s financial
statements to arrive at a cumulative score that forecasts whether a firm will go bankrupt. The model was
originally intended for large public manufacturing companies. However, the model was later modified
for practitioners to use with private companies and nonmanufacturing companies. Although this model
is widely used by practitioners, one notable limitation is that the model does not calculate a probability
of bankruptcy. In addition, some research asserts that half of the accounting ratios are not statistically

fn 1 For updates on the Altman Z-Score and how it is used to predict financial distress, see Edward I. Altman and Edith Hotchkiss,
Corporate Financial Distress and Bankruptcy: Predict and Avoid Bankruptcy, Analyze and Invest in Distressed Debt, 3rd ed. (Hobo-
ken, NJ: John Wiley & Sons, Inc., 2005).

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