What is the Altman Z Score?

The Altman Z-Score formula was originally developed by Edward Altman, an assistant professor at NYU (at the time). It was designed to predict the probability that a company would go bankrupt within two years using financial metrics that assess solvency, profitability, leverage, liquidity, and turnover.

The focus of this model is to protect your downside. A high Altman Z Score does not represent a good buy; however, a low failing score raises red flags that you should dig into.

The main problem with the Altman Z formula is that the formula is not suited for many industries. Industries that operate with high leverage, such as airlines and utilities will show a higher risk of bankruptcy.

Industries with negative working capital, such as many retail and restaurant companies will also exhibit the same high level of bankruptcy.

 

The Altman Z Score Formula

The basic formula may look complicated, but we’ll break it down for you.

Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 +1 X5

where:

X1 = Working Capital / Total Assets
X2 = Retained Earnings / Total Assets
X3 = EBITDA / Total Assets
X4 = Market Value of Equity / Total Liabilities
X5 = Net Sales / Total Assets

I’ll get to what each one means, but first, Here are the rules for interpreting the Altman Z score.

When Z is >= 3.0, the firm is most likely safe based on the financial data.
When Z is 2.7 to 3.0, the company is probably safe from bankruptcy, but this is in the grey area and caution should be taken.
When Z is 1.8 to 2.7, the company is likely to be bankrupt within 2 years.
When Z is <= 1.8, the company is highly likely to be bankrupt.

The components of the Z score aren’t rocket science.

Just simple, well thought out ratios covering all your main bases:

• Profitability
• Liquidity
• Solvency
• Leverage
• Turnover

Let’s take a look at each of the variables and see what it can indicate in a company.

 

Altman X1 = Working Capital / Total Assets
Working Capital/Total Assets = (Current Assets – Current Liabilities)/Total Assets

This is a simple ratio to understand.

This ratio provides information about the short term financial position of the business based on the balance sheet.

The more working capital there is compared to the total assets, the better the liquidity situation.

 

Altman X2 = Retained Earnings / Total Assets

Retained earnings is the percentage of net earnings that isn’t paid out as dividends – hence the word “retained”.

The company will use it to operate the business. It can be reinvested or used to pay off debt. Up to management.

But when you combine it with total assets, the purpose of the ratio is now to measure how much the company relies on debt.

 

Altman X3 = EBIT / Total Assets

This ratio looks at the company’s ability to generate profits from its assets before deducting interest and taxes. EBIT/Total Assets is a variation of ROA. Instead of net income, EBIT is used in the numerator.

 

Altman X4 = Market Value of Equity / Total Liabilities

Out of the 5 components, this is the most controversial.

This ratio is supposed to show you how much of the company’s market value could decline before liabilities exceed assets.

The weakness is the market value of equity, aka market cap or stock price x shares outstanding.

The problem is that if the stock price is high, then this ratio goes up.

 

Altman X5 = Net Sales / Total Assets

This ratio is just asset turnover.

I use it all the time outside of the Altman Z score as well as it is a great indicator of efficiency and business quality when comparing against previous years.

Quite simply, it is looking at the dollar of sales generated by the company for every dollar of assets.

The more money you can generate from assets, the better.

If two people start with $1,000 in total assets, but person A generates $1,000 while person B generates $2,000, the winner is a no-brainer.

 

Revised Altman Z Score

There is also two revised Altman Z score which is adjusted for non-manufacturing companies and for the emerging market.

The revised formula is:

Revised Altman Z (Non-Manufacturers) = 6.56*X1 + 3.26*X2 + 6.72*X3 + 1.05*X4

Revised Altman Z (Emerging Markets) = 3.25 + 6.56*X1 + 3.26*X2 + 6.72*X3 + 1.05*X4

 

Accuracy and Effectiveness

In its initial test, the Altman Z-Score was found to be 72% accurate in predicting bankruptcy two years before the event, with a Type II error (false negatives) of 6% (Altman, 1968).

In a series of subsequent tests covering three periods over the next 31 years (up until 1999), the model was found to be approximately 80%–90% accurate in predicting bankruptcy one year before the event, with a Type II error (classifying the firm as bankrupt when it does not go bankrupt) of approximately 15%–20% (Altman, 2000).

Here are two examples of a good stock and a stock that is possibly in distress:

 

 

More reading:
1. https://en.wikipedia.org/wiki/Altman_Z-score
2. http://pages.stern.nyu.edu/~ealtman/Zscores.pdf