What is Altman Z-Score
The Altman Z-Score is a statistical measure used to predict the probability of a company going bankrupt. It is an important measure to gauge a company’s creditworthiness using data publicly available in the annual report of a company.
Use of Altman Z-Score?
As we are all aware, the fundamental idea to make higher profits in a stock market is “Buy Low – Sell High.” This means we need to buy a stock at its lowest possible value and sell it when it reaches its highest possible value to make higher returns. Hence, it happens many times that a potential investor waits for the stock to go as low as possible before entering into it. Therefore, in haste to buy a stock at its lowest value, one should not neglect its chances of going bankrupt. Hence, investors use the Z-score formula to check a company’s creditworthiness and decide on safer investments. During the big financial crisis in 2008, the Z-Score formula has helped Altman to predict the crisis beforehand. The formula is highly effective and has a reliability of 80-90% in predicting distressed companies in advance.
Edward I. Altman developed the formula in 1968 for evaluating the default rate of publicly listed manufacturing companies. The formula was initially tested on a set of 66 manufacturing companies. Revised versions developed in later years have extended its usability to all types of companies – public, private, manufacturing, and non-manufacturing firms.
The Formula for Altman Z-score
Z-score for Public Companies
The Z-Score formula is composed of a combination of a few financial ratios. Each ratio captures information on different aspects of the heath of the firm. The equation for Z-Score is the sum of all the ratios multiplied by pre-determined weights. The formula for publicly listed companies is:
Z score = (x1*1.2) + (x2*1.4) + (x3*3.3) + (x4*0.6) + (x5*1)
x1 (liquidity factor) = Working capital/Total Assets
x2 (profitability factor) = Retained Earnings/ Total Assets
x3 (profitability factor) = Operating Earnings/Total Assets
x4 (compares company’s value vs. liabilities) = Market Capitalization/Total Liabilities
x5 (efficiency factor)= Sales/Total Assets
In general, the lower the Z-score value, the higher the probability of a company going bankrupt.
FULL RATIO ANALYSIS (32 RATIOS)
We have covered the complete ratio analysis – its significance, application, importance, and limitations, and all 32 RATIOS of ratio analysis that are structured and categorized into 6 important heads.
A value of less than 1.81 means there is a high chance for the company to file bankruptcy or high distress company.
If it is between 1.81 and 2.99, the company has a medium chance of going bankrupt or a medium distress company. A score higher than 2.99 means the company is far from filing bankruptcy or b a low distress company.
For a more conservative approach, 2.69 is the cut-off mark instead of 2.99.
The above score has proved to predict if a company is likely to bankrupt before one year with 95% accuracy and before two years with 83% accuracy.
For calculation, use our Altman Z- Score Calculator
Z- Score for Private Companies
The financial ratios and their weights vary a bit to predict bankruptcy in private companies. The formula for private companies is:
Z score = (x1*3.107) + (x2*0.998) + (x3*0.420) + (x4*0.717) + (x5*0.847)
x1 = EBIT/Total Assets
x2 = Net sales/Total Assets
x3 = Book value of equity/Total Liabilities
x4 = Working capital/Total Assets
x5 = Retained Earnings/Total Assets
If the score is less than 1.23: there is a high chance for the company to file for bankruptcy or high distress company.
Between 1.23 and 2.9: Company has a medium chance of going bankrupt or medium distress company.
Higher than 2.9: Company is far from filing bankruptcy or low distress company