Altman’s Z-Score Model
What is Altman’s Z-Score Model?
Altman’s
Z-Score model is a numerical measurement that is used to predict the chances of
a business going bankrupt in the next two years. The model was developed by
American finance professor Edward Altman in 1968 as a measure of the financial
stability of companies.
Summary
- Altman’s Z-score Model is a numerical
measurement that is used to predict the chances of bankruptcy.
- American Edward Altman published the
Z-score Model in 1968 as a measure of the probability of a company going
bankrupt.
- Altman’s Z-score model combines five
financial ratios to predict the probability of a company becoming insolvent in
the next two years.
Altman’s Z-Score Model
Explained
The
Z-score model was introduced as a way of predicting the probability that a
company would collapse in the next two years. The model proved to be an
accurate method for predicting bankruptcy on several occasions.
According to studies, the model showed an accuracy of 72% in predicting
bankruptcy two years before it occurred, and it returned a false positive of
6%. The false-positive level was lower compared to the 15% to 20% false-positive
returned when the model was used to predict bankruptcy one year before it
occurred.
When
creating the Z-score model, Altman used a weighting system alongside other
ratios that predicted the chances of a company going bankrupt. In total, Altman
created three different Z-scores for different types of businesses. The
original model was released in 1968, and it was specifically designed for
public manufacturing companies with assets of more than $1 million. The
original model excluded private companies and non-manufacturing companies with
assets less than $1 million.
Later
in 1983, Altman developed two other models for use with smaller private
manufacturing companies. Model A Z-score was developed specifically for private
manufacturing companies, while Model B was created for non-publicly traded
companies. The 1983 Z-score models comprised varied weighting, predictability
scoring systems, and variables.
Altman’s Z-Score Model
Formula
The Altman’s Z-score
formula is written as follows:
ζ = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
Where:
Zeta (ζ) is the Altman’s Z-score
A is
the Working Capital/Total Assets ratio
B is
the Retained Earnings/Total Assets ratio
C is
the Earnings Before Interest and Tax/Total Assets ratio
D is
the Market Value of Equity/Total Liabilities ratio
E is
the Total Sales/Total Assets ratio
Examples
Let
us understand the concept with some examples.
Publicly Held Manufacturing Firms
This
formula is designed for publicly held manufacturing firms with more than $ 1
million of net worth values.
The
five financial ratios used in the calculation of this Altman Z score formula
are as follows:
The formula for this
model for determining the probability that a firm to close bankruptcy is:
Altman Z Score formula = (1.2 x A) +
(1.4 x B) + (3.3 x C) + (0.6 x D) + (0.999 x E)
- In this model, if the Z value is greater
than 2.99, the firm is said to be in the “safe zone” and has a negligible
probability of filing bankruptcy.
- If the Z value is between 2.99 and 1.81,
then the firm is in the “grey zone” and has a moderate probability of
bankruptcy.
- And finally, if the Z value is below 1.81,
then it is said to be in the “distress zone” and has a very high probability of
reaching the stage of bankruptcy.
Private firms
The original formula calculates the Altman z score is
modified to fit in case of private firms, and the business ratios used in case
of this are:
The actual Altman Z Score
formula for this model for determining the probability for a firm to close
bankruptcy is:
Z’ = (0.717 x A) + (0.847 x B) +
(3.107 x C) + (0.420 x D) + (0.998 x E)
- In this model, if the Z value is greater
than 2.99, the firm is said to be in the “safe zone” and has a negligible
probability of filing bankruptcy.
- If the Z value is between 2.99 and 1.23,
then the firm is in the “grey zone” and has a moderate chance of bankruptcy.
- And finally, if the Z value is below 1.23,
it is said to be in the “distress zone” and has a very high probability of
reaching the stage of bankruptcy.
Non-manufacturing firms (Developed
and Emerging Markets)
The
original formula is slightly modified to be used in the case of firms that are
non-manufacturing and operating in emerging markets. We use only four financial
ratios in this model. The four ratios are as follows:
The actual Altman
z score analysis formula for this model for determining the
probability for a nonmanufacturing firm operating in developed markets to file
bankruptcy is as follows:
Z’’ = (6.56 x A) +
(3.26 x B) + (6.72 x C) + (1.05 x D)
The actual formula
Altman Z Score formula for this model for determining the probability for a non-manufacturing firm operating in emerging markets to file bankruptcy is as
follows:
Z’’ = 3.25 + (6.56 x
A) + (3.26 x B) + (6.72 x C) + (1.05 x D)
- In this model, if the Z value is
greater than 2.6, the firm is said to be in the “safe zone” and has a
negligible probability of filing a bankruptcy.
- If the Z value is between 2.6 and 1.1,
then the firm is in the “grey zone” and has a moderate chance of bankruptcy.
- If the Z value is below 1.1, then it
is said to be in the “distress zone” and has a very high probability of
reaching the stage of bankruptcy.
What Z-Scores Mean
Usually,
the lower the Z-score, the higher the odds that a company is heading for
bankruptcy. A Z-score that is lower than 1.8 means that the company is in
financial distress and with a high probability of going bankrupt. On the other
hand, a score of 3 and above means that the company is in a safe zone and is
unlikely to file for bankruptcy. A score of between 1.8 and 3 means that the
company is in a grey area and with a moderate chance of filing for bankruptcy.
Investors
use Altman’s Z-score to make a decision on whether to buy or sell a company’s
stock, depending on the assessed financial strength. If a company shows a
Z-score closer to 3, investors may consider purchasing the company’s stock
since there is minimal risk of the business going bankrupt in the next two
years.
However,
if a company shows a Z-score closer to 1.8, the investors may consider selling
the company’s stock to avoid losing their investments since the score implies a
high probability of going bankrupt.
The Five Financial Ratios
in Z-Score Explained
The
following are the key financial ratios that make up the Z-score model:
1. Working Capital/Total
Assets
Working
capital is the difference between the current assets of a company and its current
liabilities. The value of a company’s working capital determines its
short-term financial health. A positive working capital means that a company
can meet its short-term financial obligations and still make funds available to
invest and grow.
In
contrast, negative working capital means that a company will struggle to meet
its short-term financial obligations because there are inadequate current
assets.
2. Retained
Earnings/Total Assets
The
retained earnings/total assets ratio shows the amount of retained earnings or
losses in a company. If a company reports a low retained earnings to total
assets ratio, it means that it is financing its expenditure using borrowed
funds rather than funds from its retained earnings. It increases the
probability of a company going bankrupt.
On
the other hand, a high retained earnings to total assets ratio shows that a
company uses its retained earnings to fund capital expenditure. It shows that
the company achieved profitability over the years, and it does not need to rely
on borrowings.
3. Earnings Before
Interest and Tax/Total Assets
EBIT,
a measure of a company’s profitability, refers to the ability of a company to
generate profits solely from its operations. The EBIT/Total Assets ratio
demonstrates a company’s ability to generate enough revenues to stay profitable fund ongoing operations and make debt payments.
4. Market Value of
Equity/Total Liabilities
The
market value, also known as market
capitalization, is the value of a company’s equity. It is obtained by
multiplying the number of outstanding shares by the current price of stocks.
The
market value of the equity/total liabilities ratio shows the degree to which a
company’s market value would decline when it declares bankruptcy before the
value of liabilities exceeds the value of assets on the balance sheet. A high
market value of equity to total liabilities ratio can be interpreted to mean
high investor confidence in the company’s financial strength.
5. Sales/Total Assets
The
sales to total assets ratio shows how efficiently the management uses assets to
generate revenues vis-à-vis the competition. A high sales-to-total assets ratio
is translated to mean that the management requires a small investment to
generate sales, which increases the overall profitability of the company.
In
contrast, a low or falling sales-to-total assets ratio means that the
management will need to use more resources to generate enough sales, which will
reduce the company’s profitability.
Advantages & Disadvantages
of Z-score model
Advantages
- It helps in decision-making and
analysis.
- It helps to assess the creditworthiness and solvency of a business.
- It is very useful in the stock
market for analysis. It helps investors to decide whether to buy a stock
or not.
Disadvantages
- The calculation of the model is
dependent on the samples. Therefore, such instances may only sometimes give
clear and precise data, thus doubting the Altman z score accuracy.
- Continuous change in the business and
financial world is exposing companies to various forms of risk from time to
time, affecting profits. Thus, in such circumstances, prediction based on past
data will not yield the correct result.
- Altman z score accuracy is
also doubtful because is unable to predict when the business may actually
become bankrupt.The blog is written by,
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