Altman Z-Score
The Altman Z-score is the output of a credit-strength test that gauges a publicly traded manufacturing company's likelihood of bankruptcy.
Definition:
The Altman Z-Score is a credit strength test that measures the likelihood of bankruptcy for publicly traded manufacturing companies. It combines several financial ratios to calculate a composite score that predicts the probability of a company going bankrupt within the next two years.
Origin:
The Altman Z-Score was developed by Edward I. Altman, a professor of finance at New York University's Stern School of Business, in 1968. Altman created this model by analyzing the financial data of multiple companies to help investors and creditors assess a company's financial health.
Categories and Characteristics:
The Altman Z-Score is primarily used for manufacturing companies, but there are variations for non-manufacturing and private companies. The formula is:
Z = 1.2 * (Working Capital/Total Assets) + 1.4 * (Retained Earnings/Total Assets) + 3.3 * (EBIT/Total Assets) + 0.6 * (Market Value of Equity/Total Liabilities) + 1.0 * (Sales/Total Assets).
The lower the score, the higher the risk of bankruptcy. Generally, a Z-Score below 1.8 indicates high bankruptcy risk, between 1.8 and 3.0 indicates moderate risk, and above 3.0 indicates low risk.
Case Studies:
Case 1: Manufacturing Company A has the following financial data: Working Capital of $2 million, Retained Earnings of $3 million, EBIT of $1 million, Market Value of Equity of $5 million, Total Liabilities of $4 million, and Total Assets of $10 million. The Z-Score is calculated as:
Z = 1.2 * (2/10) + 1.4 * (3/10) + 3.3 * (1/10) + 0.6 * (5/4) + 1.0 * (10/10) = 3.25.
Therefore, Company A has a low risk of bankruptcy.
Case 2: Manufacturing Company B has the following financial data: Working Capital of $0.5 million, Retained Earnings of $1 million, EBIT of $0.2 million, Market Value of Equity of $1 million, Total Liabilities of $3 million, and Total Assets of $5 million. The Z-Score is calculated as:
Z = 1.2 * (0.5/5) + 1.4 * (1/5) + 3.3 * (0.2/5) + 0.6 * (1/3) + 1.0 * (5/5) = 1.67.
Therefore, Company B has a high risk of bankruptcy.
Common Questions:
1. Is the Altman Z-Score applicable to all industries?
Answer: The Altman Z-Score was originally designed for manufacturing companies, but there are variations for non-manufacturing and private companies.
2. Can the Z-Score fully predict bankruptcy?
Answer: While the Z-Score has a high accuracy in predicting bankruptcy, it cannot fully predict all situations. Investors should use it in conjunction with other financial analysis tools for a comprehensive assessment.
