What is Altman’s Z-Score Model?
Altman’s Z-Score model is a numerical measurement that is used to predict the chances of
a business going bankrupt in the next two years. The model was developed by American
finance professor Edward Altman in 1968 as a measure of the financial stability of
companies.
What Z-Scores Mean
Usually, the lower the Z-score, the higher the odds that a company is heading for
bankruptcy. A Z-score that is lower than 1.8 means that the company is in financial distress
and with a high probability of going bankrupt. On the other hand, a score of 3 and above
means that the company is in a safe zone and is unlikely to file for bankruptcy. A score of
between 1.8 and 3 means that the company is in a grey area and with a moderate chance
of filing for bankruptcy.
Investors use Altman’s Z-score to make a decision on whether to buy or sell a company’s
stock, depending on the assessed financial strength. If a company shows a Z-score closer to
3, investors may consider purchasing the company’s stock since there is minimal risk of the
business going bankrupt in the next two years.
However, if a company shows a Z-score closer to 1.8, the investors may consider selling the
company’s stock to avoid losing their investments since the score implies a high probability
of going bankrupt.
Altman Z-Score: What It Is, Formula, How to Interpret Results
What Is the Altman Z-Score?
The Altman Z-score is the output of a credit-strength test that gauges a publicly traded
manufacturing company's likelihood of bankruptcy.
KEY TAKEAWAYS
The Altman Z-score is a formula for determining whether a company, notably in the
manufacturing space, is headed for bankruptcy.
The formula takes into account profitability, leverage, liquidity, solvency, and activity
ratios.
An Altman Z-score close to 0 suggests a company might be headed for bankruptcy, while
a score closer to 3 suggests a company is in solid financial positioning.
How to Calculate the Altman Z-Score
One can calculate the Altman Z-score as follows:
Altman Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
Where:
A = working capital / total assets
B = retained earnings / total assets
C = earnings before interest and tax / total assets
D = market value of equity / total liabilities
E = sales / total assets
A score below 1.8 means it's likely the company is headed for bankruptcy, while
companies with scores above 3 are not likely to go bankrupt. Investors can use Altman
Z-scores to determine whether they should buy or sell a stock if they're concerned
about the company's underlying financial strength. Investors may consider purchasing a
stock if its Altman Z-Score value is closer to 3 and selling or shorting a stock if the value
is closer to 1.8.
In more recent years, however, a Z-Score closer to 0 indicates a company may be in
financial trouble. In a lecture given in 2019 titled "50 Years of the Altman Score,"
Professor Altman himself noted that recent data has shown that 0—not 1.8—is the
figure at which investors should worry about a company's financial strength.
How Is the Altman Z-Score Calculated?
The Altman Z-score, a variation of the traditional z-score in statistics, is based on five
financial ratios that can be calculated from data found on a company's annual 10-K
report. The formula for Altman Z-Score is 1.2*(working capital / total assets) +
1.4*(retained earnings / total assets) + 3.3*(earnings before interest and tax / total
assets) + 0.6*(market value of equity / total liabilities) + 1.0*(sales / total assets).
How Should an Investor Interpret the Altman Z-Score?
Investors can use Altman Z-score Plus to evaluate corporate credit risk. A score below
1.8 signals the company is likely headed for bankruptcy, while companies with scores
above 3 are not likely to go bankrupt. Investors may consider purchasing a stock if its
Altman Z-Score value is closer to 3 and selling, or shorting, a stock if the value is
closer to 1.8. In more recent years, Altman has stated a score closer to 0 rather than
1.8 indicates a company is closer to bankruptcy.
Did the Altman Z-Score Predict the 2008 Financial Crisis?
In 2007, Altman's Z-score indicated that the companies' risks were increasing
significantly. The median Altman Z-score of companies in 2007 was 1.81, which is very
close to the threshold that would indicate a high probability of bankruptcy. Altman's
calculations led him to believe a crisis would occur that would stem from corporate
defaults, but the meltdown, which brought about the 2008 financial crisis, began with
mortgage-backed securities (MBS); however, corporations soon defaulted in 2009 at
the second-highest rate in history.
The Five Financial Ratios in Z-Score Explained
The following are the key financial ratios that make up the Z-score model:
1. Working Capital/Total Assets
Working capital is the difference between the current assets of a company and its
current liabilities. The value of a company’s working capital determines its short-term
financial health. A positive working capital means that a company can meet its short-term
financial obligations and still make funds available to invest and grow.
In contrast, negative working capital means that a company will struggle to meet its short-
term financial obligations because there are inadequate current assets.
2. Retained Earnings/Total Assets
The retained earnings/total assets ratio shows the amount of retained earnings or losses
in a company. If a company reports a low retained earnings to total assets ratio, it means
that it is financing its expenditure using borrowed funds rather than funds from its
retained earnings. It increases the probability of a company going bankrupt.
On the other hand, a high retained earnings to total assets ratio shows that a company
uses its retained earnings to fund capital expenditure. It shows that the company
achieved profitability over the years, and it does not need to rely on borrowings.
3. Earnings Before Interest and Tax/Total Assets
EBIT, a measure of a company’s profitability, refers to the ability of a company to generate
profits solely from its operations. The EBIT/Total Assets ratio demonstrates a company’s
ability to generate enough revenues to stay profitable and fund ongoing operations and
make debt payments.
4. Market Value of Equity/Total Liabilities
The market value, also known as market capitalization, is the value of a company’s equity. It
is obtained by multiplying the number of outstanding shares by the current price of stocks.
The market value of the equity/total liabilities ratio shows the degree to which a company’s
market value would decline when it declares bankruptcy before the value of liabilities
exceeds the value of assets on the balance sheet. A high market value of equity to total
liabilities ratio can be interpreted to mean high investor confidence in the company’s
financial strength.
5. Sales/Total Assets
The sales to total assets ratio shows how efficiently the management uses assets to
generate revenues vis-à-vis the competition. A high sales to total assets ratio is translated
to mean that the management requires a small investment to generate sales, which
increases the overall profitability of the company.
In contrast, a low or falling sales to total assets ratio means that the management will
need to use more resources to generate enough sales, which will reduce the company’s
profitability.
What Is Distress Cost?
Distress cost refers to the expense that a firm in financial distress faces beyond the cost of
doing business, such as a higher cost of capital. Companies in distress tend to have a
harder time meeting their financial obligations, which translates to a higher probability of
default. Distress costs may extend to the need to sell assets quickly and at a loss to cover
immediate needs.
KEY TAKEAWAYS
Distress cost refers to the greater expense that a firm in financial distress incurs beyond
the cost of doing business.
Distress costs can be tangible, such as having to pay higher interest rates or more money
to suppliers upfront.
Distress costs can also be intangible, such as a loss of employee morale and productivity.
Distress costs are broken down into two categories: ex-ante (before the event) and ex-post
(after the event—e.g., bankruptcy).
