Altman Z-Score

The Altman Z-Score is a financial formula that calculates the likelihood of a company facing bankruptcy within two years. Developed by Edward I. Altman in 1968, this formula integrates various financial ratios to quantify a firm’s financial health. It’s typically used by investors, financial analysts, and portfolio managers to assess the credit risk of different companies. The Altman Z-Score has evolved over the years and now includes different versions for public companies, private companies, and non-manufacturing companies.

Components of the Altman Z-Score

The Altman Z-Score employs five key financial ratios that collectively provide insight into different aspects of a company’s financial stability:

  1. Working Capital/Total Assets (WC/TA): This ratio measures the proportion of total assets that is tied up in working capital. Working capital is calculated as current assets minus current liabilities. A higher ratio suggests that the firm has a good short-term financial health.

  2. Retained Earnings/Total Assets (RE/TA): This ratio indicates how much of the company’s assets are financed by retained earnings. Retained earnings are the cumulative amount of profit kept in the company rather than paid out as dividends. A higher ratio implies a more financially stable business with a strong history of profitability.

  3. Earnings Before Interest and Taxes/Total Assets (EBIT/TA): This ratio assesses the firm’s operating efficiency. It compares the earnings before interest and taxes (EBIT) to the total assets, revealing how well the company is utilizing its assets to generate profits from its core operations.

  4. Market Value of Equity/Total Liabilities (MVE/TL): This ratio measures the extent to which a firm’s assets can decline in value before the liabilities exceed the assets. Market value of equity is the total market value of all outstanding shares, and total liabilities are the sum of current and long-term liabilities. A higher ratio suggests a lower risk of insolvency.

  5. Sales/Total Assets (S/TA): This ratio measures the efficiency of the firm’s asset use in generating revenue. A higher ratio indicates that the company is effectively using its assets to generate sales.

Calculation of Altman Z-Score

The original Z-Score formula for public manufacturing companies is as follows:

Z = 1.2(WC/TA) + 1.4(RE/TA) + 3.3(EBIT/TA) + 0.6(MVE/TL) + 1.0(S/TA)

Each ratio is multiplied by a standard coefficient, which was statistically determined by Altman to have predictive power for assessing financial distress. After computing the weighted sum of these ratios, the resulting Z-Score can be interpreted as follows:

Modified Z-Score for Non-Manufacturing and Private Companies

Because the original model was devised primarily for publicly traded manufacturing companies, adjustments were needed for its application to other sectors. Altman developed alternative models for non-manufacturing and private firms.

Non-Manufacturing Companies

The modified formula for non-manufacturing firms removes the Sales/Total Assets component:

Z = 6.56(WC/TA) + 3.26(RE/TA) + 6.72(EBIT/TA) + 1.05(MVE/TL)

Private Firms

For privately held companies, the Market Value of Equity is not readily available, so the book value of equity is used instead:

Z = 0.717(WC/TA) + 0.847(RE/TA) + 3.107(EBIT/TA) + 0.42(BVE/TL) + 0.998(S/TA)

Where BVE stands for the Book Value of Equity.

Historical Performance and Limitations

The Altman Z-Score has proven to be highly effective historically, with early tests showing an accuracy of approximately 72% two years prior to bankruptcy. It was able to identify companies that would fail within this period but also produced some false positives and false negatives. While the formula remains a useful tool, it has some limitations:

Application in Modern Finance

Despite its limitations, the Altman Z-Score remains widely utilized in credit assessments, investment screening, and risk management. Its role has been particularly noted in the realms of leveraged finance and high-yield bond markets, where the financial fragility of firms is a critical concern.

Use by Financial Firms

Several financial institutions include the Altman Z-Score in their credit analysis toolkits:

Academic and Educational Influence

Universities and financial education programs frequently teach the Altman Z-Score as part of their curriculum on financial statement analysis and corporate finance. Its clear methodology and straightforward computation make it an excellent teaching tool for understanding the core concepts of financial risk and profitability.

Conclusion

The Altman Z-Score is an essential tool in financial risk assessment, offering a quantitative measure of a company’s likelihood of bankruptcy. By combining multiple financial ratios into a single score, it provides a more comprehensive view of financial health than any single ratio alone. While it has some limitations and should be used in conjunction with other analytic tools and professional judgement, it continues to be a valuable part of the toolkit for investors, analysts, and financial managers globally.