Altman Z-Score: What It Is, Formulas, and How to Interpret Results
The result of a credit-strength test used to determine the possibility of bankruptcy for publicly listed manufacturing companies is the Altman Z-score.
How to Interpret the Altman Z-Score
A company’s annual 10-K report data may be used to create five financial measures that comprise the Altman Z-score, a statistical variant of the classic Z-score. It determines if a corporation is likely to go bankrupt using profitability, leverage, liquidity, solvency, and activity.
Stern Finance at NYU The Altman Z-score formula was created by Professor Edward Altman in 1967 and published in 1968. Altman has consistently updated his Z-score throughout time. Altman examined 86 struggling businesses from 1969 to 1975, 110 from 1976 to 1995, and 120 from 1996 to 1999. He discovered that the Z-score had an accuracy range of 82% to 94%.
He published an upgraded version in 2012 under the name Altman Z-score Plus, which can be used to assess both public and private businesses, manufacturing and non-manufacturing businesses, and American and foreign businesses. Altman Z-score Plus is a tool for assessing business credit risk. The Altman Z-score is now recognized as an accurate indicator of credit risk.
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 the company is likely 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 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 it 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 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.
Financial Crisis of 2008
Certain asset-related securities’ credit ratings in 2007 were higher than they ought to have been. The firms’ risks were dramatically rising, according to the Altman Z-score, and they may be on the verge of bankruptcy.
According to Altman’s calculations, the average company’s Altman Z-score in 2007 was 1.81. The credit ratings of these firms were Bs. This showed that 50% of the companies should have had worse ratings, were in serious financial trouble, and had a high likelihood of going bankrupt.
According to Altman’s estimates, the credit market would crash, and there would be a catastrophe. He anticipated that corporate failures would cause the crisis, but mortgage-backed securities (MBS) set off the catastrophe that resulted in the 2008 financial crisis.
However, in 2009, companies quickly saw the second-highest rate of defaults in history.
The Altman Z-Score: How Is It Calculated?
A company’s annual 10-K report data may be used to create five financial measures that comprise the Altman Z-score, a statistical variant of the classic Z-score. The Altman Z-Score is calculated by multiplying working capital by 1.2, retained profits by 1.4, earnings before interest and taxes by 3.3, market value of equity by 0.6, and sales by 1.0 to get the score.
The Altman Z-Score: How Should an Investor Interpret It?
Altman Z-score Plus is a tool investors may use to assess business credit risk. Companies with ratings above 3 are less likely to file for bankruptcy than those with scores below 1.8, indicating bankruptcy’s likelihood. If a stock’s Altman Z-Score value is closer to 3, investors might think about buying it, and if it’s closer to 1.8, they might think about shorting it and selling it. According to Altman, A number closer to 0 than 1.8 suggests that a firm is on the verge of bankruptcy.
Did the 2008 Financial Crisis Predict the Altman Z-Score?
Altman’s Z-score in 2007 showed that the firms’ risks were dramatically rising. The average Altman Z-score for businesses in 2007 was 1.81, almost the cutoff point for a high likelihood of bankruptcy. According to Altman’s predictions, a crisis resulting from corporate defaults would happen, but the breakdown that caused the 2008 financial crisis started with mortgage-backed securities (MBS). Nevertheless, companies started defaulting in 2009 at the second-highest rate in history.
Conclusion
- The Altman Z-score is a model for predicting a company’s likelihood of insolvency, particularly in the manufacturing sector.
- Profitability, leverage, liquidity, solvency, and activity ratios are all included in the calculation.
- A corporation may be on the verge of bankruptcy if its Altman Z-score is close to zero, while a number closer to three indicates sound financial standing.
