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 organization 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 the 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 importance of Altman Z Score, how it is calculated and its importance in the overall company analysis.
Learn more about careers in financial modeling.
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 value’ 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.
The formula serves a lot of essential purposes. Some of them are enumerated here:
Those stakeholders who are interested to determine the creditworthiness of a company use the formula to ascertain credit risk. For instance, banks as an institution use the ratio to determine the risk of issuing loans to companies and firms. Calculating the value is simple and easy as everything is based on strong data.
Turnaround managers and mergers and acquisition managers use the 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.
The formula is used to predict corporate defaults or bankruptcy or in academic language, financial distress position of companies.
The formula is based on the discriminant analysis technique in statistical analysis.
The formula uses multiple variables from the income statement and balance sheet of companies.
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 = Total Sales / Total Assets
This is the asset turnover ratio and is a measure of how effectively the firm uses its assets to generate sales.
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.
4. For companies from emerging markets
Formula: Z3 = 6.56*T1 + 3.26*T2 + 6.72*T3 + 1.05*T4A + 3.25
If the Z value is higher than 3.0, the company is a ‘safe’ company.
If this value 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 value. According to the above formula, Colgate’s Z-value is 20, which is well above 3.0 (safe number).
You can download this formula calculation in Excel.
The formula is a complete tool to predict bankruptcy. Apply this Bankruptcy formula to your companies and share your results with me.