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Altman Z-Score Model: Likelihood of bankruptcy

Altman Z-Score Model: Likelihood of bankruptcy

DEFINITION:

The Altman Z-Score (in Finnish, Altmanin Z-tunnusluku) represents a model for the calculation of the company's likelihood of financial distress, i.e., its chances of going bankrupt. The formula was developed by Assistant Professor of Finance at New York University Edward I. Altman in 1968. It is widely used by investors while choosing the company for investment, as it helps to forecast the failure of a business up to two years prior to distress.

How to calculate:

The original formula for publicly traded companies:

\[ { Z-Score } = {1.2X1 + 1.4X2 + 3.3X3 + 0.6X4+ 1.0X5} \]

Altman Z-Score is a function of the five financial ratios: liquidity, leverage, profitability, solvency and sales activity of the business. Thus, the formula is based on the following financial ratios:

X1. Company’s Liquidity

Determines the ability of a firm to cover short-term liabilities.

\[X1 = {Working\ Capital \over Total\ Assets} \]
\[X1 = {Total\ Current\ Assets\ - Total\ Current\ Liabilities \over Total\ Assets}\]

X2. Leverage of a firm

Measures accumulated profits in relation to assets. The companies with high Retained Earnings, relative to Total Assets, finance their assets through retention of profits and do not use much debt.

\[ X2 = {Retained\ Earnings \over Total\ Assets}\]

X3. Profitability

Measure of the productivity of company’s assets, independent of taxes or leverage factors. Determines the amount of profit the firm’s assets are producing.

\[X3 = {Earnings\ Before\ Interest\ and\ Taxes\ (EBIT) \over Total\ Assets} \]
\[X3 = {Operating\ Income \over Total\ Assets} \]

X4. Solvency

Compares the company’s value and its liabilities. Helps to understand how much the company's assets (company’s market value) can decline in value before the liabilities exceed the assets and the company becomes insolvent.

\[ X4 = {Market\ Value\ Equity \over Book\ Value\ of\ Total\ Liabilities}\]
\[ X4 = {Market\ Cap \over Total\ Liabilities}\]

X5. Sales activity

Ability of the company assets to generate sales. It indicates how efficiently the business is using its assets to generate sales or revenue.

\[ X5 = Asset\ Turnover\ Ratio = {Sales \over Total\ Assets} = {Revenue \over Total\ Assets}\]

RESULT INTERPRETATION:

  • The lower the score, the higher the probability of the company’s bankruptcy.
  • Score < 1.8: Distress Zone, high risk of going into bankruptcy. According to Altman's study there is more than 80% of chances of bankruptcy within two years.
  • 1.8 < Score < 2.99: Grey Zone , sign of possible problems.
  • Score > 2.99: Safe Zone, negligible probability of bankruptcy, solid financial position.

Note:

1. This indicator does not apply to financial companies.

2. This article represents the Altman Z-score for public traded manufacturing companies. Nevertheless, it should be noted that there are several variants of the Altman Z-score model, each of which uses different variables. There are also models for:

  • Non-publicly traded companies
  • Non-manufacturing companies
  • Emerging market companies
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