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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Altman Z-Score

What it is:

The Altman Z-Score (named after Edward Altman, the New York University professor who devised it) is a statistical tool used to measure the likelihood that a company will go bankrupt.

Though Altman devised the Z-Score in the 1960s, the notion of trying to predict which companies would fail was far from new at that time. However, Altman added a statistical technique called multivariate analysis to the mix of traditional ratio-analysis techniques, and this allowed him to consider not only the effects of several ratios on the "predictiveness" of his bankruptcy model, but to consider how those ratios affected each other's usefulness in the model.

Altman developed the Z-Score after evaluating 66 companies, half of which had filed for bankruptcy between 1946 and 1965. He started out with 22 ratios classified into five categories (liquidity, profitability, leverage, solvency and activity) but eventually narrowed it down to five ratios.

How it works (Example):

Altman's Z-Score determines how likely a company is to fail. The formula does this by evaluating seven simple pieces of data, all of which should be available in the company's public disclosure.

The Standard Z-Score
The formula for the Z-Score (which incorporates those seven simple pieces of data) is:

Z-Score = ([Working Capital / Total Assets] x 1.2) + ([Retained Earnings / Total Assets] x 1.4) + ([Operating Earnings / Total Assets] x 3.3) + ([Market Capitalization / Total Liabilities] x 0.6) + ([Sales / Total Assets] x 1.0)

In general, the lower the score, the higher the chance of bankruptcy. For example, a Z-Score above 3.0 indicates financial soundness; below 1.8 suggests a high likelihood of bankruptcy.

Z-Score for Private Companies
In 2002, Altman advocated a revised Z-Score formula for private companies. The private company version weights the variables differently and uses book value of equity in place of market capitalization. The formula is:

Z-Score = ([Working Capital / Total Assets] x 0.717) + ([Retained Earnings / Total Assets] x 0.847) + ([Operating Earnings / Total Assets] x 3.107) + ([Book Value of Equity / Total Liabilities] x 0.420) + ([Sales / Total Assets] x 0.998)

Z-Score for Nonmanufacturers
Altman originally developed the Z-Score for manufacturers, primarily because those were the companies in his original sample. However, the emergence of large, public service companies prompted him to develop a second Z-Score model for non-manufacturing companies. The formula is essentially the same as before; it just excludes the last component (sales / total assets) because Altman wanted to minimize the effects of manufacturing-intensive asset turnover.

Z-Score = ([Working Capital / Total Assets] x 1.2) + ([Retained Earnings / Total Assets] x 1.4) + ([Operating Earnings / Total Assets] x 3.3) + ([Market Capitalization / Total Liabilities] x 0.6)

The first ratio (working capital / total assets) is a good indicator of a firm's ability to make good on what it owes in the next few months. The second ratio is a good indicator of how in debt the company is and whether it has a history of profitability. The third ratio is a measure of efficiency in that it indicates how many cents the company generates in earnings for every dollar of assets it owns. The fourth ratio is a fluid measure of the market's "confidence" in the company. The fifth ratio is similar to the third ratio in that it measures the company's efficiency in delivering sales from its assets.

Why it Matters:

The Z-Score is a commonly used metric with wide appeal, though it is just one of many credit scoring models in use today that essentially combine quantifiable financial indicators with a small number of variables in an attempt to predict whether a firm will fail.

Over time, however, the Z-Score has proved to be one of the most reliable predictors of bankruptcy -- so much so that analysts often equate certain Z-Scores with corresponding bond ratings. In fact, when Altman reevaluated his methods by examining 86 distressed companies from 1969 to 1975 and then 110 bankrupt companies from 1976 to 1995 and later 120 bankrupt companies from 1996 to 1999, the Z-Score was between 82% and 94% accurate. The old "garbage in, garbage out" motto applies, however: if the company financials are misleading or incorrect, the Z-Score will be, too.

It's important to remember that changes in a company's Z-Score are as important, if not more important, than the Z-Score itself. After all, knowing a company is heading down the wrong path is better than learning about it after the fact. For example, Enron's Z-Score gave it the equivalent of a BBB bond rating at year-end 1999, but it had a score equal to a B rating by June 2001 -- unlike the ratings agencies, which rated Enron as BBB until just before it filed for bankruptcy.

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