The Altman Z-Score is a formula that can help investors and creditors assess the financial health and risk of a company. It was developed by Professor Edward Altman in 1968 as a way to predict the probability of bankruptcy within two years. The Altman Z-Score is based on five financial ratios that measure the profitability, leverage, liquidity, solvency, and activity of a company. These ratios are weighted by coefficients that were estimated using a sample of manufacturing firms that had either survived or filed for bankruptcy.
How an Altman Z-Score is Calculated
The Altman Z-Score formula is as follows:
Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5
X1 = working capital / total assets
X2 = retained earnings / total assets
X3 = earnings before interest and taxes / total assets
X4 = market value of equity / total liabilities
X5 = sales / total assets The Altman Z-Score can be interpreted as follows12:
A score below 1.8 indicates a high risk of bankruptcy.
A score between 1.8 and 3 indicates a moderate risk of bankruptcy.
A score above 3 indicates a low risk of bankruptcy.
The Altman Z-Score can be used by investors and creditors to evaluate the financial performance and stability of a company, and to compare it with other companies in the same industry or sector. It can also be used to identify potential opportunities or threats in the market, such as undervalued or overvalued stocks, or distressed or healthy companies.
Success of Altman Z-Score
In its initial test the Altman Z-Score system was shown to be 72% accurate in predicting bankruptcy 2 years before the event. In further testing looking at 3 periods over the next 31 years the model was found to be 80-90% accurate in forecasting insolvency within 1 year.
Limitations of Altman Z-Score
However, the Altman Z-Score also has some limitations that users should be aware of:
- It was originally designed for manufacturing firms, and may not be applicable to other types of businesses, such as service or non-manufacturing firms.
- It relies on accounting data that may be subject to manipulation or errors, and may not reflect the true value or performance of a company.
- It does not take into account other factors that may affect the financial situation or outlook of a company, such as macroeconomic conditions, industry trends, competitive advantages, or growth potential.
Therefore, the Altman Z-Score should not be used as the sole criterion for making investment or lending decisions, but rather as one of the tools that can provide useful insights and information. Users should also conduct their own due diligence and analysis before making any financial judgments or actions.