Altman Z Score/Bankruptcy Score to Predict Bankruptcy

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Edward Altman

There are many companies going bankrupt worldwide. Here’s a post on using Altman Z-Score or bankruptcy score to predict bankruptcy.

Stock picking is a skill and such skills come through experience—Good and bad

There are literally hundreds of parameters to check before you invest in a company.

Is this method of checking all the parameters for a company a fool proof method?

NO.

It still requires your judgment to decide whether to invest in the company or not.

Now, let’s check one such parameter in company analysis. It’s called Altman Z-Score.

The origin of Altman Z Bankruptcy score

Altman Z-Score Definition

The formula called ” Z-Score formula”, used for predicting bankruptcy, was developed and published by Edward Altman in 1968.

Initially, the Altman Z-Score was found to be 72% accurate in predicting bankruptcy 2 years prior to the bankruptcy. Isn’t it interesting?

Recent results

Morgan Stanley strategy analyst, Graham Secker, 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.

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?

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.

1. For Private companies

Formula

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

Formula

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.

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.

Example of Altman Z Score/ Bankruptcy Score

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).