Altman Z-Score

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Introduction

Evaluating a company’s financial performance has always involved a degree of uncertainty, fortunately there are statistical measures that has been utilized to more objectively audit financial strength.

Altman’s Z-Score model is a numerical measurement that is used to predict the chances of a business going bankrupt. The model was developed by American finance professor Edward Altman in 1968 as a measure of the financial stability of companies.

Altman’s Z-score model is considered an effective method of predicting the state of financial distress of any organization by using multiple balance sheet values and corporate income.

The formula takes into consideration essential measures of performance and creates a robust tool for evaluating a company’s health and performance.

In Altman’s original paper, the Z-Score proved to be 72% accurate in predicting bankruptcy within the prior two years.

In subsequent tests, Altman found the Z-Score to be between 80% and 90% accurate in predicting bankruptcies.

Altman’s Z-score Model Computing

The Z-score model is based on five key financial ratios, and it relies on the information contained in the 10-K report provided by the U.S. Securities and Exchange Commisson. This five financial ration were selected from 22 financial variables by means of Multiple Discriminant Analysis.

Currently, the Altman’s Z-score formula is written as follows:

ζ = .012A + .014B + .033C + .006D + 1.0E

Where:

Zeta (ζ) is the Altman’s Z-score
A is the Working Capital/Total Assets ratio
B is the Retained Earnings/Total Assets ratio
C is the Earnings Before Interest and Tax/Total Assets ratio
D is the Market Value of Equity/Total Liabilities ratio
E is the Total Sales/Total Assets ratio

The original weights for the financial ratios that Edward Altman found, are shown in the next figure, taken from the very original paper:

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Once the calculation is completed, the scores fall into zones, classified as the Safe Zone, the Grey Zone, and the Distress Zone, as shown in the figure bellow.

A Z-Score that falls in the Distress Zone is an indicator of financial distress. However, it is equally important to take note of scores that fall in the Grey Zone and that decrease year over year, as decreasing Z-Scores are also an indicator of deteriorating financial health.

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Example of computing the Altman Z-Score

Next example was taken from the class on Risk Analysis, part of the Diploma on Financial Markets ans Risk Analysis, taught at School of Economics, National Autonomous University of Mexico:

#Altman Z-Score for LA INDUSTRIAL year 2017
TA <- 13248385 # Total of Assets
TL <- 6127795 # Total of Liabilities
WorkCap <- TA - TL # Working Capital
RE <- 3132660 #Retained Earnings
EBIT <- 490456 # Earning Before Interests and Taxes
MV <- 3570000 # Market Value (Social Capital)
SALES <- 68694818
A <- WorkCap/TA
B <- RE/TA
C <- EBIT/TA
D <- MV/TL
E <- SALES/TA
Z <-  .012*A + .014*B + .033*C + .006*D + .999*E
cat("Altman Z-Score for LA INDUSTRIAL (Year 2017): ", Z, " The Company is Healthy")

## Altman Z-Score for LA INDUSTRIAL (Year 2017):  5.194439  The Company is Healthy

#Altman Z-Score for LA INDUSTRIAL year 2018
TA <- 14379249 # Total of Assets
TL <- 3307420 # Total of Liabilities
WorkCap <- TA - TL # Working Capital
RE <- 981877 #Retained Earnings
EBIT <- 1312076 # Earning Before Interests and Taxes
MV <- 10722224 # Market Value (Social Capital)
SALES <- 86119042
A <- WorkCap/TA
B <- RE/TA
C <- EBIT/TA
D <- MV/TL
E <- SALES/TA
Z <-  .012*A + .014*B + .033*C + .006*D + .999*E
cat("Altman Z-Score for LA INDUSTRIAL (Year 2018): ", Z, " The Company is Healthy")

## Altman Z-Score for LA INDUSTRIAL (Year 2018):  6.015789  The Company is Healthy

#Altman Z-Score for LA INDUSTRIAL year 2019
TA <- 22557893 # Total of Assets
TL <- 8502976 # Total of Liabilities
WorkCap <- TA - TL # Working Capital
RE <- 660788 #Retained Earnings
EBIT <- 2877247 # Earning Before Interests and Taxes
MV <- 11469131 # Market Value (Social Capital)
SALES <- 101461538
A <- WorkCap/TA
B <- RE/TA
C <- EBIT/TA
D <- MV/TL
E <- SALES/TA
Z <-  .012*A + .014*B + .033*C + .006*D + .999*E
cat("Altman Z-Score for LA INDUSTRIAL (Year 2019): ", Z, " The Company is Healthy")

## Altman Z-Score for LA INDUSTRIAL (Year 2019):  4.51352  The Company is Healthy

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References

Altman Z-Score as an Indicator of Financial Health

Altman’s Z-Score Model

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