Altman Z-Score – Meaning, Use, History, Formula, and Interpretation

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.

History

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
Altman's Z Score

Interpretation

In general, the lower the Z-score value, the higher the probability of a company going bankrupt.

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

Interpretation

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

For Non-Manufacturing Company:

Z-Score = x1*6.56 + x2*3.26 + x3*6.72 + x4*1.05

Where,

  • x1 = Liquidity Factor = Working Capital / Total Assets
  • x2 = Leverage Factor = Retained Earnings / Total Assets
  • x3 = Profitability Factor = EBIT / Total Assets
  • x4 = Solvency Factor = MV or BV of Equity / Total Liabilities
  • x5 = Activity Factor = Net Sales / Total Assets

Interpretation

If the score less than 1.1 is treated as very bad, while more than 2.6 is a good indicator of solvency.

Example of Altman Z-Score

Suppose Mr. X, an investor, is willing to invest in a company. He has two options, that is, to invest in A Ltd. or B Ltd. The details of the two companies are as below:

ParticularsA Ltd. ($)B Ltd. ($)
Working Capital250,000440,000
Retained Earnings500,000(100,000)
EBIT250,000(60,000)
MV / BV of Equity1,500,0001,170,000
Total Liability500,0001,500,000
Net Sales500,0001,800,000
Total Assets1,000,0002,000,000

Z-Score of A Ltd.:

(0.25*1.2) + (0.5*1.4) + (0.25*3.3) + (3*0.6) + (0.5*0.999) = 4.1245

Z-Score of B Ltd.:

(0.22*1.2) + (-0.05*1.4) + (-0.03*3.3) + (0.78*0.6) + (0.9*0.999) = 1.4621



Sanjay Borad

Sanjay Bulaki Borad

MBA-Finance, CMA, CS, Insolvency Professional, B'Com

Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.

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