Definition
The Altman Z-Score is a statistical tool used in finance to predict the likelihood of a company going bankrupt within the next two years. Created by Edward I. Altman in 1968, it combines five different financial ratios, using three balance sheet measurements and two performance measurements, to produce a single output that gauges a firm’s financial health. A lower Z-score indicates higher bankruptcy risk while a higher Z-score indicates financial stability.
Phonetic
The phonetic pronunciation of “Altman Z-Score” would be: AHLT-muhn ZEE Skawr
Key Takeaways
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- The Altman Z-Score is a financial formula that helps to determine the credit strength and bankruptcy risk of a company. It is based on various profitability, leverage, liquidity, solvency, and activity ratios.
- The Z-Score assigns three ranges of scores: Above 2.99 means safe-zone or low risk of bankruptcy, between 1.81 and 2.99 is grey-zone, and below 1.81 is distress-zone, which indicates high risk of bankruptcy.
- The formula helped predict many corporate bankruptcies during the early 70s and continues to renew itself by suggesting upgrades and revisions over time to increase its predictive accuracy.
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Importance
The Altman Z-Score is a crucial business and finance term as it assists investors and financial analysts in predicting the likelihood of a company going bankrupt. The formula was introduced by Edward Altman in 1968 and uses five financial ratios calculated from data found on a company’s annual 10K report. It provides a comprehensive picture of a company’s financial health, enabling effective decision-making, risk assessment and management. Not only does it allow investors to avoid potentially risky investments, but it also provides companies an early warning sign to improve their financial situation, thereby enhancing the stability and overall health of the financial markets.
Explanation
The Altman Z-Score is an analytical tool used for assessing a company’s financial health and predicting the likelihood of bankruptcy within a 2-year timeframe. This statistical formula considers a variety of financial data from a company’s balance sheet to provide a single score that can be used to evaluate the risk of financial distress. The score effectively gaughs the company’s ability to continue operations without being bankrupt. This is especially beneficial for creditors or lenders to mitigate the risk associated with their investment.The purpose of the Altman Z-Score is essentially to provide a financial snapshot of a company, allowing potential investors, shareholders, and stakeholders to make informed decisions about investment risk and potential returns. It’s important to note that while the Z-Score is a powerful tool, it is not the only determinant of a company’s financial health – other factors, such as industry position, economic conditions, and management quality, should also be considered. In summary, the Altman Z-Score is a key resource for stakeholders in their analysis of a business’s viability, financial stability, and the risk of bankruptcy.
Examples
1. Eastman Kodak Company (2012): In 2012, this famous American technology company declared bankruptcy with an Altman Z-Score of 0.55, which is significantly below the 1.8 threshold indicating financial distress.2. General Motors (2009): Before its bankruptcy filing in 2009, General Motors also saw a declining Altman Z-Score from 1.6 in 2005 to 0.48 in 2008, serving as a warning sign of its deteriorating financial health.3. Fortescue Metals Group (2016): This Australian iron ore company experienced a sharp drop in its Altman Z-Score from 1.9 in 2011 to -0.3 in 2016. Despite these indicators of financial distress, Fortescue was able to navigate through its challenges thanks to a recovery in the iron ore market and its cost reduction initiatives. This case serves as an example of how the Altman Z-Score can signal potential risks, but the actual outcome may also depend on a variety of other factors.
Frequently Asked Questions(FAQ)
What is the Altman Z-Score?
The Altman Z-Score is a statistical tool used to measure the likelihood of a company going bankrupt. It is based on five financial ratios calculated from data found in a company’s annual 10K report.
Who developed the Altman Z-Score?
The score was developed by New York University Professor Edward I. Altman in 1968.
What are the five ratios used in the Altman Z-Score?
The five ratios are: working capital/total assets, retained earnings/total assets, earnings before interest and taxes/total assets, market value of equity/book value of total liabilities, sales/total assets.
How is the Altman Z-Score calculated?
The score is calculated with a specific formula, which weights each of the five ratios according to its importance in predicting bankruptcy.
What does the final Z-Score mean?
Generally, a score above 2.99 means the company is in good health (unlikely to go bankrupt), a score between 1.81 and 2.99 is in the grey zone (could go either way), and a score below 1.81 means the company is at risk of bankruptcy.
Can I use the Altman Z-Score for non-manufacturing companies?
Yes, but with some caution. Altman revised the original model in 2012 to cater more to non-manufacturing companies, but the Z-Score is most accurate when used with manufacturing firms.
Is the Altman Z-Score definitive proof a company will or won’t go bankrupt?
No. While the Z-Score is an excellent tool, it is just that—a tool. It is best used in conjunction with other analyses and measures.
Where do I find the information to calculate an Altman Z-Score?
All required information can be found on a company’s publicly available financial statements, specifically, the balance sheet and income statement.
Can the Altman Z-Score be used for a private company?
The traditional Z-Score is designed mainly for public manufacturing firms with market capitalization of $1 million or more. It can be challenging to use this for private firms as determining market value of equity is difficult, but a revised version (Altman Z’-Score) can be used with more success.
When should I use the Altman Z-Score when evaluating companies for investing?
It is recommended to use the score as part of your fundamental analysis when considering long-term investment opportunities. It should be used along with other financial, industry specific, and macro-economic indicators.
Related Finance Terms
- Bankruptcy Prediction
- Financial Distress
- Working Capital
- Retained Earnings
- Total Assets
Sources for More Information
