What is the Altman Z-Score?
The Altman Z-score is an invaluable metric born out of a credit-strength test, purposed to gauge a publicly traded manufacturing company’s likelihood of bankruptcy.
Key Insights
- Bankruptcy Prediction Engine: The Altman Z-score formula is designed to forewarn of a manufacturing company’s potential bankruptcy.
- Comprehensive Formula: It incorporates several critical financial ratios—including profitability, leverage, liquidity, solvency, and activity ratios.
- Interpreting the Scores: An Altman Z-score closer to 0 means a high risk of bankruptcy, while a score nearing 3 indicates solid financial health.
Dynamics Behind the Altman Z-Score
Born from statistical analysis, the Altman Z-score relies on five fundamental financial ratios derived from a company’s annual filings. It serves as an analytical divergence from the classical z-score, focusing expressly on predicting insolvency. This revolutionary analysis was propounded by NYU Stern Finance Professor Edward Altman in 1967, and was published a year later. With decades of empirical testing, including distress analyses of 86 companies from 1969 to 1975, 110 companies from 1976 to 1995, and 120 companies from 1996 to 1999, the Z-score’s accuracy impressively ranged between 82% and 94%.
In 2012, Altman advanced his initial framework by introducing the Altman Z-score Plus, capable of evaluating not only public and private companies in manufacturing but also non-manufacturing and international firms.
The Calculation Method
The Altman Z-score is computed using the following equation:
Altman Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
Where:
- A = Working capital / Total assets
- B = Retained earnings / Total assets
- C = Earnings before interest and tax / Total assets
- D = Market value of equity / Total liabilities
- E = Sales / Total assets
Interpreting the Scores
- Below 1.8: Likely heading towards bankruptcy.
- Above 3: Unlikely to face bankruptcy.
- Closer to 0: Recent findings suggest this value denotes even greater financial peril.
Real-World Application: The 2008 Financial Crisis
The Altman Z-score was particularly prescient during the prelude to the 2008 financial debacle. Evaluating data from 2007, the median Altman Z-score of the time was a critical 1.81; a stark warning showing that 50% of firms were sustaining significantly high distress levels, akin to a B credit rating. Altman had anticipated a correlated eruption in corporate defaults, logically predicated upon these findings.
Ultimately, while the financial crisis propagated from the meltdown of mortgage-backed securities, corporate defaults soared to historical peaks in 2009, affirming Altman’s incisive predictions.
Investor Takeaways:
- A meticulous observer should heed the Altman Z-score when evaluating stocks, combined with other analysis tools for holistic insight.
- Consider a higher Z-score as a more favorable indicator of corporate endurance.
- Utilize the innovative Altman Z-score Plus for expanding beyond the traditional manufacturing sector.
Altogether, leveraging the Altman Z-score can arm investors, financial analysts, and corporate stakeholders with intrinsic indicators of economic sturdiness and a forward-looking measure for bankruptcy risk.
Embark on smarter investing by integrating the Altman Z-score into your financial analysis arsenal. Arming yourself with such predictive foresight is not just advantageous—it’s virtually indispensable.
Related Terms: financial ratios, bankruptcy prediction, credit risk, z-score.
References
- NYU Stern. “Predicting Financial Distress of Companies: Revisiting the Z-Score and Zeta Models”, Page 18.
- NYU Stern. “Professor Edward Altman Launches Digital App for Renowned Z-Score, Altman Z-Score Plus”.
- NYU Stern. “Predicting Financial Distress of Companies: Revisiting the Z-Score and Zeta Models”, Page 26.
- NYU Stern. “A 50-Year Retrospective on Credit Risk Models, the Altman Z-Score Family of Models and Their Applications to Financial Markets and Managerial Strategies”, Page 20.
- NYU Stern. “Special Report on Defaults and Returns in the High-Yield Bond Market: The Year 2007 in Review and Outlook”, Pages 9-13 and 27.
- NYU Stern. “Special Report on Defaults and Returns in the High-Yield Bond Market: The Year 2007 in Review and Outlook”, Pages 9-13 and 26.
- NYU Stern. “Special Report On Defaults and Returns in the High-Yield Bond and Distressed Debt Market: The Year 2009 in Review and Outlook”, Page 3.
