What is the Altman Z-Score?
The Altman(named after Edward Altman, the New York University professor who devised it) is a statistical tool used to measure the likelihood that a company go bankrupt.
Though Altman devised the bankruptcy model, but to consider how those ratios affected each other's usefulness in the model.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
How the Z-Score Works
Altman'sdetermines 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 formula for the(which incorporates those seven simple pieces of data) is:
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. For example, a above 3.0 indicates financial soundness; below 1.8 suggests a high likelihood of .
for Private Companies
= ([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)
Altman originally developed thefor 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 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.
= ([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 '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 the Z-Score Matters
The 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 fail.is a commonly used metric with wide appeal, though it is just one of many
Over time, however, the analysts often equate certain 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 was between 82% and 94% accurate. The old 'garbage in, garbage out' motto applies, however: if the company financials are misleading or incorrect, the be, too.has proved to be one of the most reliable predictors of -- so much so that
It's important to remember that changes in a company'sare as important, if not more important, than the itself. After all, knowing a company is heading down the wrong path is better than learning about it after the fact.