Altman Z Score

Professor Edward Altman invented the Altman Z score in 1968 to predict the chances of companies' insolvency. It not only shows bankruptcy but also helps in measuring the financial health of companies. Altman Z score includes five financial ratios to predict bankruptcy or predict the probability of a company facing insolvency in the next two years.

The formula to derive Altman Z Score

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Altman Z score is used to determine Bankruptcy

Altman Z Score is a widely used metric by analysts and investors to analyze companies' financial position. It indicates that the companies' risks were increasing, and they may have been heading towards bankruptcy. It does not only indicate whether companies are moving towards bankruptcy, but it also indicates how financially stable and healthy they are.The Z score can be used to evaluate how financially strong a company's stock is. By looking at the Z score model zones will give a better understanding of companies. Investors should look for companies with an Altman Z Score value closer to 2.99 or higher than that. It is useful to predict the corporate defaults and measure the financial distress position of companies. It includes values from the company's income statement and balance sheet. Banking institutions and creditors use this model to calculate their risk of defaulting on loans.

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Interpretation of Altman Z Score

Altman Z score below 1.8 signals that the company may be headed towards bankruptcy or may likely face bankruptcy, while the score above 3 indicates that the company is financially good and has minimal chances to face bankruptcy. Investors should consider companies that have a score above or closer to 3. Companies with a score between 1.8 to 2.99 indicate that they are financially stable and have less chance to face bankruptcy. Professor Altman has stated that the companies with a Z score closer to 0 rather than 1.8 indicate that they are nearest to facing bankruptcy.

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Altman Z score accuracy

Studies indicate the model was found 72% accurate in predicting bankruptcy two years before it occurred, and it resulted in 6% false positives. It increased over years and has shown 80%-90% reliability. It was originally designed for manufacturing companies with having assets of more than 10 lakh. This model has been modified to apply to other types of companies, such as non-manufacturing and emerging markets. It did excellent work in differentiating bankrupt and non-bankrupt companies.

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How to calculate Altman Z Score

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Formula contents

• Working Capital - It is also known as net working capital, and it measures the company's short-term liquidity and efficiency position. It is calculated by subtracting current assets and current liabilities.

• Retained Earnings - It is the portion of earnings that the company retains back into the business for growth and expansion. Or we can also say it refers to the amount of the net income left over after the distribution of dividends to its shareholders.

• EBIT - Earnings Before Interest and Tax (EBIT) indicates the company's profitability before paying interest and tax. EBIT is also known as operating Profits or Net Income before interest and tax. And it is found in the Income Statement of the company.

• Market Capitalization - It is also commonly known as a market cap, and it refers to the market value of the company's outstanding shares. It is calculated by multiplying total shares outstanding by the current market price of the share.

• Total Sales - It is a sum of total sales revenue generated by the company from its operations, and it is found in the company's Income Statement.

• Total Assets - Total assets are the total value of assets owned by a company. Total assets are reported on a company's balance sheet.

• Total Liabilities - Those are a combination of the company's debts and other obligations that it owes to others. There are three categories of liabilities such as short-term liabilities, long-term liabilities, and other liabilities. Total liabilities are found in the company's Balance Sheet.

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Altman Z Score Model (Zones of Discrimination)

If the Z score value of the company is greater than 2.99, then it is considered in the safe zone and not at risk of bankruptcy. The company is considered to be in the grey zone if its Z score is less than 2.99 and greater than 1.8, which indicates it has minimal chances of going bankrupt. And if the Z score of the company is less than 1.8, then it is considered in a distress zone and has a high possibility of insolvency, or the company is heading towards bankruptcy.

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History

Mr. Edward Altman was born on 5 June 1941 and is a Professor of Finance, Emeritus at Stern School of Business of New York University. He published his world-famous Altman Z Score model in 1668, which is known for the prediction of bankruptcy. Prof. Altman is a pioneer in the development of credit risk management and bankruptcy prediction models and is a leading academic on the High Yield and Distressed Debt markets. He is an expert in many areas such as bankruptcy, hedge funds, private equity funds, risk management, leveraged buyouts, credit/debit markets, corporate finance, etc. Altman's Z-score model was created for publicly traded manufacturing companies. Later, a version of the Z-score was developed for small companies, privately-owned companies, and non-manufacturing companies.

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Conclusion

The Altman Z Score is an important metric to assess the financial strength of companies. Investors should look for companies that have an Altman Z-score above 2.99 as it indicates they are financially strong. Companies with Z-score between 1.8 to 2.99 are considered stable, and investors should check other financial factors while analyzing. Companies with a low Z-score below 1.8 are considered in the distress zone, which indicates a high possibility of bankruptcy. Investors should beware of companies with a Z-score below 1.8.