Altman zscore (Finance)

Altman Z-score

Designed Jobin Mathew

• The Z-score formula for predicting bankruptcy was published in 1968 by Edward I. Altman, who was, at the time, an Assistant Professor of Finance at New York University.

• The Z-Score Test lets you use statistical techniques to predict the likelihood of bankruptcy within the next two years.

• Dr. Altman's test was developed using 66 companies, The test achieved an accuracy rate of 95%.

• The financial ratios come directly from a company's financial statements.

Z score bankruptcy model:

Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + .999T5

T1 = Working Capital / Total Assets

T2 = Retained Earnings / Total Assets

T3 = Earnings Before Interest and Taxes / Total Assets

T4 = Market Value of Equity / Total Liabilities

T5 = Sales/ Total Assets

Zones of Discrimination:

Z > 2.99 -“Safe” Zones

1.81 < Z < 2.99 -“Grey” Zones

Z < 1.81 -“Distress” Zones

Z-score estimated for private firms

T1 = (Current Assets − Current Liabilities) / Total Assets

T2 = Retained Earnings / Total Assets

T3 = Earnings Before Interest and Taxes / Total Assets

T4 = Book Value of Equity / Total Liabilities

T5 = Sales/ Total Assets

Z' Score Bankruptcy Model:

Z' = 0.717T1 + 0.847T2 + 3.107T3 + 0.420T4 + 0.998T5

Zones of Discrimination:

Z' > 2.9 -“Safe” Zone

1.23 < Z' < 2. 9 -“Grey” Zone

Z' < 1.23 -“Distress” Zone

Z-score estimated for non-manufacturer industrials & emerging market credits

T1 = (Current Assets − Current Liabilities) / Total Assets

T2 = Retained Earnings / Total Assets

T3 = Earnings Before Interest and Taxes / Total Assets

T4 = Book Value of Equity / Total Liabilities

Z-Score bankruptcy model:

Z = 6.56T1 + 3.26T2 + 6.72T3 + 1.05T4

Zones of discriminations:

Z > 2.6 -“Safe” Zone

1.1 < Z < 2. 6 -“Grey” Zone

Z < 1.1 -“Distress” Zone

3 Easy Steps to Calculate the Z-score

Steps

1

2

3

1

• To calculate a manufacturer's Z-score from scratch, the first step is to identify the seven items listed on the balance sheet and income statement used in the calculation:

2

• Together, these seven figures are used to create five financial ratios, each identified by Altman as having the greatest forecasting power as to a company's financial strength:

- Ratio A, Working Capital / Total Assets, is a liquidity measure. Working capital is comprised of cash and any other assets that can be turned into cash on fairly short notice. The more working capital a firm has, the more cushion it has to meet any bills coming due.

- Ratio B, Retained Earnings / Total Assets, is a measure of leverage. It tells us whether the firm is paying for assets using profits or using debt. A high ratio indicates that profits are being used to fund growth, while a low ratio indicates that growth is being financed through increasing debt levels.

- Ratio C, EBIT / Total Assets, is a profitability measure also known as return on assets (ROA). It measures the amount of operating income generated by each dollar of assets.

- Ratio D, Market Cap / Total Liabilities, is a measure of the market's confidence in the company as reflected in its stock price. If the ratio falls below 1.0, then the market is saying that the firm is worth less than what it owes, or in other words, insolvent.

- Ratio E, Sales / Total Assets, is a measure of efficiency in that it describes the amount of sales generated by each dollar of assets

3

• The third and final step is to use these ratios in the Z-score formula to create the final value: 

Z-score = 1.2*(A) + 1.4*(B) + 3.3*(C) + 0.6*(D) + 1.0*(E)

It should now be easier to see why the Z-score is such a good measure of a firm's financial health. A healthy firm

(A) maintains enough liquid assets to pay whatever bills are due,

(B) funds its growth with profits,

(C) invests in assets that generate profits for its owners,

(D) gets a vote of confidence from investors via its share price, and

(E) converts its investments into revenues for the company.

Altman Z-Score Calculation

Balance Sheet Items:Current Assets 3000Current Liabilities 6000Total Liabilities 4000Total Assets 4000Retained Earnings 2000Market Value of Equity 5000

Income Statement Items:EBIT 1000Sales 2000

T1 (Working Capital/Total Assets) -0.75T2 (Retained Earning/Total Assets) 0.5T3 (EBIT/Total Assets) 0.25T4 (Market Value of Equity/Total Liabilities) 1.25T5 (Sales/Total Assets) 0.5

Altman Z-Score = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + .999T5 1.8745

Thank You