CMA Final · Strategic Performance Management and Business Valuation

Corporate Failure: formula sheet

Full chapter guide

Key formulas

Classification of causes: Causes of failure = Internal (controllable) + External (environmental); Always split your answer under these two heads, with a few points under each.
Stages of decline: Latent weakness → Financial distress → Crisis/Insolvency; Name the stage when you describe a warning sign. Early stages are the best time to turn around.
Economic failure test: Return on capital employed < Cost of capital over a sustained period; A company can be economically failing while still solvent. Say 'sustained', not one bad year.
Liquidity warning ratio: Current ratio = Current assets ÷ Current liabilities; A falling trend is a warning sign. Do not state a fixed 'safe' value as a rule; it varies by industry.
Technical insolvency test: Technical insolvency: cash and liquid resources < debts currently due, while Total assets > Total liabilities; A cash-flow (flow) problem. Net worth is still positive.
Legal insolvency test: Legal insolvency: Total liabilities > Fair value of total assets, so Net worth = Assets − Liabilities < 0; A balance sheet (stock) problem. Use fair or realisable values, not only book values.
Net worth: Net worth = Total assets − Total liabilities; Positive in technical insolvency, negative in legal insolvency.
Current ratio: Current ratio = Current assets ÷ Current liabilities; A low ratio is a warning sign of distress. It is a signal, not proof of insolvency.
Interest coverage ratio: Interest coverage = EBIT ÷ Interest expense; A ratio below 1 means operating profit does not cover interest, a common distress signal.
Original Z-score (public manufacturing firms): Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5; Use for listed manufacturing companies. Some books write the weights as decimals (0.012, 0.014, 0.033, 0.006, 0.999) with ratios in percentages; use the form the question gives.
Variables X1 to X5: X1 = Working capital ÷ Total assets; X2 = Retained earnings ÷ Total assets; X3 = EBIT ÷ Total assets; X4 = Market value of equity ÷ Total liabilities; X5 = Sales ÷ Total assets; Working capital = current assets − current liabilities. Total liabilities means book value of all debt and liabilities.
Zones for original model: Z > 2.99: safe; 1.81 ≤ Z ≤ 2.99: grey; Z < 1.81: distress; Some texts use 1.8 and 3.0 as rounded cut-offs. Use what the question states.
Z′-score (private manufacturing firms): Z′ = 0.717 X1 + 0.847 X2 + 3.107 X3 + 0.420 X4 + 0.998 X5; X4 uses book value of equity ÷ total liabilities. Zones: Z′ > 2.9 safe; 1.23 to 2.9 grey; Z′ < 1.23 distress.
Z″-score (non-manufacturing and emerging markets): Z″ = 6.56 X1 + 3.26 X2 + 6.72 X3 + 1.05 X4; No sales ratio, so it removes industry effects of asset turnover. X4 uses book value of equity. Zones: Z″ > 2.6 safe; 1.1 to 2.6 grey; Z″ < 1.1 distress.
Springate model: S = 1.03A + 3.07B + 0.66C + 0.4D; A = working capital ÷ total assets; B = EBIT ÷ total assets; C = profit before tax ÷ current liabilities; D = sales ÷ total assets. A score below 0.862 classifies the firm as likely to fail. Confirm the weights given in the question, and use those.
Beaver's best single ratio: Cash flow to total debt = (net income + depreciation) ÷ total debt; Lower values signal higher failure risk. Beaver tested one ratio at a time.
Altman Z-score (original, listed manufacturers): Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5; Zones: above 2.99 safe, 1.81 to 2.99 grey, below 1.81 distress. Use only if the question supplies or asks for it.
Argenti A-score logic: Defects + Mistakes + Symptoms = A-score; Qualitative marks are assigned to each part. A higher total means higher risk. Use the cut-offs given in the question or in your study material.
Common warning ratios: Current ratio = current assets ÷ current liabilities; Interest cover = EBIT ÷ interest; Gearing = debt ÷ (debt + equity); Judge by direction over several years, not one figure.
Continue-or-exit rule: Continue if going-concern value (PV of future cash flows) > liquidation value (net realisable value of assets less liabilities costs); Use present values. Include costs of closure, such as employee dues and legal costs, in the exit value.
Debt-equity ratio: Debt-equity ratio = Total debt ÷ Shareholders' equity; A high ratio points to financial restructuring as the likely remedy.
Interest coverage ratio: Interest coverage = EBIT ÷ Interest expense; A ratio below 1 means operating profit cannot pay interest. Debt relief becomes urgent.
Current ratio: Current ratio = Current assets ÷ Current liabilities; Used to judge short-term liquidity stress during the stabilisation stage.
Turnaround sequence: Diagnose → Stabilise → Restructure → Revive and grow; Learn this order. Exam answers are usually marked against these stages.

Quick revision

Corporate failure means inability to pay debts or earn adequate returns, putting survival at risk.
Causes split into internal (management, finance, operations) and external (economy, market, policy).
Financial distress comes before insolvency; a firm can be distressed without being legally insolvent.
Insolvency means inability to pay debts as they fall due, or liabilities exceeding assets.
Altman Z-Score combines several financial ratios into one number to signal bankruptcy risk.
Compute each Z-Score ratio separately before applying its weight, then add.
Compare the score with the zone cut-offs from your study material, and state the zone in words.
A low score is a warning, not proof of failure; add trend and context to your comment.
Ratio analysis for failure looks at liquidity, leverage, profitability and interest cover.
Falling current ratio with rising debt and falling margins is a classic warning pattern.
Turnaround strategies include cost cutting, asset sale, debt restructuring and change in management.
Match the remedy to the cause: a demand problem needs strategic change, not only cost cuts.

Common mistakes

Writing a generic list of causes without using facts from the case. Fix: Quote the facts given, such as rising debt or falling sales, and label each one as a cause.
Treating corporate failure as only liquidation. Fix: State both legal and economic meanings, and explain that decline is a process.
Treating financial distress and bankruptcy as the same thing. Fix: Distress is an economic condition and may be reversed. Bankruptcy is a legal process or status. A firm can be distressed for years without any legal proceeding.
Calling a firm legally insolvent because it missed a payment. Fix: A missed payment with assets above liabilities is technical insolvency. Legal insolvency needs liabilities greater than assets.
Dividing market value of equity by total assets for X4. Fix: Remember X4 is equity value ÷ total liabilities. Underline 'liabilities' when you list the formula.
Using the wrong version for a private or service company. Fix: Read the firm description first. Private manufacturer: Z′ with book equity. Service or non-manufacturing: Z″ without sales.
Mixing up univariate and multivariate models. Fix: Remember: Beaver takes one ratio at a time. Altman, Springate and Taffler combine ratios into a score.
Calling Argenti's A-score a ratio model. Fix: Argenti is qualitative. It scores management defects, mistakes and symptoms.
Listing every strategy without linking it to the case. Fix: Begin with the cause and choose only the remedies that fit it. Use facts from the case.
Jumping to growth strategies before stabilising cash. Fix: Follow the sequence: diagnose, stabilise, restructure, then grow. A firm out of cash cannot invest.

Exam tips

In case questions, tag every fact as internal or external before writing; it keeps your answer structured and scores marks for application.
Use the three stages as headings in your own notes so you can place any scenario quickly.
Always mention both financial and non-financial warning signs, such as management exits and auditor resignation.
In MCQs, check whether the item is a cause, a symptom or a stage; options often mix them.
End descriptive answers with a recommendation suited to the stage reached.
In MCQs, look for the keyword: 'unable to pay debts when due' points to technical insolvency, and 'liabilities exceed assets' points to legal insolvency.
In descriptive answers, define each term in one line, then add a comparison on liquidity versus net worth. This earns easy marks.
In case scenarios, quote figures such as net worth and coverage ratio to support your classification.