The global economic trends are often unpredictable. While one economy rises, the other falls. In the midst are companies that go bankrupt because of both external and internal economic reasons. Bankruptcy spells, in one word, disaster. The whole organisation collapses.
Worldwide, a lot of companies are going bankrupt. However, bankruptcy need not be an unannounced disaster. There is a way to predict bankruptcy and the way is known as the Altman Z Score. The Altman Z Score is a bankruptcy predicting tool.
As an investor, you need to know the long-term value of a company before investing money. As such, stock picking is a skill and such skills come through experiences, which are both good and bad. There are literally hundreds of parameters to check before you invest in a company and the Altman Z Score is one of them.
If you can know whether a company is going to become bankrupt in future, will you invest in it? Obviously, you won’t!
Is this really possible to check all the parameters for a company for complete investment security? NO. It isn’t. It still requires your judgment to decide whether to invest in the company or not.
Let’s check out the important of Altman Z Score, how it is calculated and its importance in the overall company analysis.
The Origin of Altman Z Score / Bankruptcy Score
In 1968, Edward Altman founded the ‘Z Score’ formula to predict bankruptcy. Initially, the Altman Z Score was found to be 72% accurate in predicting bankruptcy two years prior to the bankruptcy.
Isn’t it interesting?
Altman, a New York University professor, evaluated 66 companies where 50% of them had already filed for bankruptcy between 1946 and 1965. He analyzed these companies using 22 ratios, which were classified into five categories: liquidity, solvency, leverage, profitability and activity.
The accuracy of the Altman Z Score improved with time. In between 1969-1975, 1976-1995 and 1996-1995 years, 86, 110 and 120 companies were analyzed. The Altman Z Score was found to be 82% to 94% accurate.
Recently, Graham Secker, a strategy analyst with Morgan Stanley used the ‘Z Score’ in 2009 to rank a group of European companies. He found that the companies with weaker balance sheets underperformed the market more than two thirds of the time.
Purposes of Altman Z Score / Bankruptcy Score
The Altman Z Score serves a lot of essential purposes. Some of them are enumerated here:
- The Altman Z Score ascertains credit ratings and probabilities in the short-term and long-term future and for both privately-held and publicly traded companies.
- The Altman Z Score leads to robust and logical credit scoring, which is based on a significant sample of companies where their financial health or credit setbacks are analyzed and used as a predictive factor.
- The Altman Z Score credit event prediction has high accuracy value as compared to other rating agency models.
Those stakeholders who are interested to determine the credit worthiness of a company use the Altman Z Score formula to ascertain credit risk. For instance, banks as an institution use Altman Z Score to determine the risk of issuing loans to companies and firms. Calculating the Altman Z Score is simple and easy as everything is based on strong data.
Turnaround managers and mergers and acquisition managers use the Altman Z Score model to determine risks and develop strategies to mitigate the risks. Similarly, the insurance industry and the corporate governance departments use the scoring system for various purposes.
Application of Altman Z Score / Bankruptcy Score Formula
The formula is used to predict corporate defaults or bankruptcy or in academic language, financial distress position of companies.
The formula is based on discriminant analysis technique in statistical analysis.
The formula uses multiple variables from income statement and balance sheet of companies.
What’s the formula?
Altman Z-Score = 1.2*T1 + 1.4*T2 + 3.3*T3 + 0.6*T4 + 1.0*T5
Here are the key definitions from the above formula:
T1 = Working Capital / Total Assets
This ratio measures liquid assets. The companies in trouble will usually experience shrinking liquidity.
T2 = Retained Earnings / Total Assets
This ratio calculates the overall profitability of the company. Dwindling profitability is a warning sign.
T3 = Earnings before Interest and Taxes / Total Assets
This ratio shows how productive a company is in generating earnings, relative to its size.
T4 = Market Capitalization / Total Liabilities
This ratio suggests how far the company’s assets can decline before it becomes technically insolvent (i.e., its liabilities become higher than its assets).
T5 = Sales / Total Assets
This is the asset turnover ratio and is a measure of how effectively the firm uses its assets to generate sales.
Is this ratio applicable to all companies?
No. This ratio is applicable to only publicly listed and manufacturing companies.
Here’s the modification part in the above ratio.
- For Private companies
Z1 = .717*T1 + .847*T2 + 3.107*T3 + .42*T4A + .998*T5
In the above formula, T4 = Book Value of Equity / Total Liabilities
2. For non-manufacturing companies
Z2 = 6.56*T1 + 3.26*T2 + 6.72*T3 + 1.05*T4A
3. This ratio is not applicable to companies that operate with high debt such as banks & finance companies and power and energy utility companies.
4. For companies from emerging markets
Z3 = 6.56*T1 + 3.26*T2 + 6.72*T3 + 1.05*T4A + 3.25
Altman Z Score Interpretation of Bankruptcy Score
If the Z Score is higher than 3.0, the company is a ‘safe’ company.
If this score is less than 3.0, there is a high probability of the company going bankrupt.
Let’s explain this with an example. I have taken Colgate’s example to check the Altman Z-Score. According to the above formula, Colgate’s Z-Score is 20, which is well above 3.0 (safe number).
Altman Z Score Calculator
You can download this Z-Score calculation in Excel.
Are You Ready To Rock?
The Altman Z Score is a complete tool to predict bankruptcy. Apply this Altman Z Bankruptcy score on your companies and share your results with me.