Altman Z-Score: Understanding, Calculation, and Interpretation of Bankruptcy Risk

A comprehensive guide to the Altman Z-Score, its formula, and how to interpret its results to assess the likelihood of bankruptcy for publicly traded manufacturing companies.

The Altman Z-Score is a financial metric used to predict the bankruptcy risk of publicly traded manufacturing companies. Developed by Edward I. Altman in 1968, this score combines various financial ratios to assess a company’s credit strength.

Formula of Altman Z-Score

The Altman Z-Score is calculated using the following formula:

$$ Z = 1.2X_1 + 1.4X_2 + 3.3X_3 + 0.6X_4 + 1.0X_5 $$

Where:

• \( X_1 \) = Working Capital / Total Assets
• \( X_2 \) = Retained Earnings / Total Assets
• \( X_3 \) = Earnings Before Interest and Taxes (EBIT) / Total Assets
• \( X_4 \) = Market Value of Equity / Total Liabilities
• \( X_5 \) = Sales / Total Assets

Components Explained

Working Capital / Total Assets (\( X_1 \))

This ratio measures a company’s liquidity by comparing its working capital to its total assets.

Retained Earnings / Total Assets (\( X_2 \))

This ratio assesses how much profit a company reinvests in itself compared to its total assets.

EBIT / Total Assets (\( X_3 \))

This ratio evaluates the company’s operational efficiency in generating profits from its assets.

Market Value of Equity / Total Liabilities (\( X_4 \))

This measures the market perception of a company’s net worth relative to its debts.

Sales / Total Assets (\( X_5 \))

This ratio indicates the company’s asset turnover, showing how effectively it uses its assets to generate sales.

Interpretation of Altman Z-Score

Ranges and Their Meanings

• Z > 2.99: The company is in the “Safe” zone, indicating a low risk of bankruptcy.
• 1.81 < Z < 2.99: The company is in the “Gray” zone, indicating a moderate risk of bankruptcy.
• Z < 1.81: The company is in the “Distress” zone, indicating a high risk of bankruptcy.

Historical Context

The Altman Z-Score was revolutionary in the 1960s, providing a statistical approach to bankruptcy prediction. This score has since become a widely used tool by investors, analysts, and financial institutions to assess credit risk.

Applicability and Special Considerations

Applicability

While the Altman Z-Score is primarily designed for publicly traded manufacturing companies, modified versions exist for private firms and non-manufacturers.

Special Considerations

• Industry Variations: The formula’s accuracy can vary across different industries.
• Economic Conditions: Macroeconomic factors can influence financial ratios, affecting the Z-Score’s accuracy.

Examples of Altman Z-Score Calculation

Example 1

Company A has the following financial data:

• Working Capital: $500,000
• Total Assets: $2,000,000
• Retained Earnings: $300,000
• EBIT: $700,000
• Market Value of Equity: $1,200,000
• Total Liabilities: $800,000
• Sales: $2,500,000

Using the Altman Z-Score formula:

$$ Z = 1.2 \left( \frac{500,000}{2,000,000} \right) + 1.4 \left( \frac{300,000}{2,000,000} \right) + 3.3 \left( \frac{700,000}{2,000,000} \right) + 0.6 \left( \frac{1,200,000}{800,000} \right) + 1.0 \left( \frac{2,500,000}{2,000,000} \right) = 2.75 $$

Company A falls into the “Gray” zone.

Related Terms and Definitions

Financial Ratios

Quantitative measures derived from financial statement data used to assess a company’s performance and financial health.

Credit Risk

The possibility of a loss resulting from a borrower’s failure to repay a loan or meet contractual obligations.

FAQs

What does a low Altman Z-Score signify?

A low Altman Z-Score indicates a high risk of bankruptcy, suggesting that the company may face financial distress.

Can the Altman Z-Score be used for non-manufacturing companies?

Yes, but the original formula is tailored for manufacturing companies. Modified versions exist for other types of companies.

How often should the Altman Z-Score be calculated?

It should be calculated regularly, such as quarterly or annually, to monitor a company’s financial health over time.

References

• Altman, E. I. (1968). “Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy.” Journal of Finance.

Summary

The Altman Z-Score is a valuable tool for assessing the bankruptcy risk of publicly traded manufacturing companies. By combining multiple financial ratios, it provides a comprehensive measure of credit strength. While primarily designed for manufacturing firms, adaptations of the score exist for other types of companies. Regular calculation and interpretation of the Z-Score can offer critical insights into a company’s financial health.