Altman Z-Score: A reliable measure of calculating credit risk
What Is Altman Z-Score?
Altman’s Z-score Model is a numerical measurement that is used to predict the chances of bankruptcy. It is the output of a credit-strength test that gauges a publicly traded manufacturing company's likelihood of bankruptcy. Derived by Edward Altman, the Z-score model was published in 1968. The model combines five financial ratios to predict the probability of a company becoming insolvent in the next two years.
Understanding Altman Z-score
The Altman Z-score is a variation of the traditional z-score in statistics. It is based on five financial ratios that can be calculated from data found on a company's annual 10-K report which uses profitability, leverage, liquidity, solvency, and activity to predict whether a company has a high probability of becoming insolvent.
Over the years, Altman has continued to revaluate his Z-score. From 1969 until 1975, Altman looked at 86 companies in distress, then 110 from 1976 to 1995, and finally 120 from 1996 to 1999, finding that the Z-score had an accuracy of between 82 per cent and 94 per cent.
In 2012, he released an updated version called the Altman Z-score Plus that one can use to evaluate public and private companies, manufacturing and non-manufacturing companies, and U.S. and non-U.S. companies. One can use this score to evaluate corporate credit risk. The Altman Z-score has become a reliable measure of calculating 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
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
If the total score is below 1.8 it means the company is headed for bankruptcy, while companies with score 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 underlying 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 the value is closer to 1.8. A score between 1.8 and 3 is of no major significance. An investor has to wait for a company to cross any of these levels.