A formula designed to assess the probability that a company will go bankrupt within the next two years.
Altman Z-Score Details
The Altman z-score takes five basic financial ratios from a company's balance sheet and uses them to assess its performance strength. These are the ratios:
- A - working capital / total assets.
- B - retained earnings / total assets.
- C - earnings before interest and taxes / total assets.
- D - market value of equity / book value of total liabilities.
- E - sales / total assets.
Each ratio is assigned a value and then added to produce a final rating. A rating of less than 1.81 shows that a company is in serious danger of bankruptcy within two years. A rating between 1.81 and 2.99 shows that there are weaknesses. A rating of above 3.0 represents a healthy balance sheet.
Example of an Altman Z-Score
Sergio, who is not a financial expert, would like to invest a large sum of money in a winery. He looks at three different, publicly listed companies. Each of the three produces excellent wine and each sells a large quantity each year. However, the first two companies have low Altman z-score ratings which suggest that their finances are not in good shape whilst the third has a high rating which tells Sergio that its financial affairs are well-managed.
Nevertheless, Sergio decides to invest in Sun Kissed Wine which was one of the lower rated companies. Sergio has decided that the Altman z-score shows the company's current state but not the whole picture. Shares in Sun Kissed are cheap in comparison with the other two candidates, probably because growing conditions in Sun Kissed's area have been poor for three years.
Conditions have been much better this year and Sergio expects that Sun Kissed Wines will fetch a higher price when they come to market. The company's balance sheet will, he hopes, reflect improved market conditions. An Altman z-score is a useful tool for judging a company's performance and future prospects in markets where conditions are stable. Its predictive capacities are more limited in fluctuating market conditions.
Significance of an Altman Z-Score
Originally, investors only used the Altman z-score to assess publicly held manufacturing companies in the United States, which had a net worth of over $1 million. This was because these companies had accurate financial records, which were generally available. Financial analysts and statisticians have designed variations of the Altman z-score to cover companies that operate in emerging markets or non-manufacturing.
Some experts hold that the Altman z-score is largely descriptive of current status and not predictive of future outcomes. However, the Altman Z-score's success rate of over eighty percent does suggest that it is a useful predictive tool.
History of an Altman Z-Score
Edward L.Altman developed the Altman z-score in 1968 when he was an Assistant Professor of Finance at New York University. Work and research in this field had been going on since the 1930s but Altman's contribution gave financial analysts a simpler and more accurate tool which helped them to assess a company's health. The Altman z-score is accessible to any layman who can read a balance sheet and is widely used and readily understood.