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How to calculate Altman Z-Score formula?
The Altman Z-score is measured on the basis of five different ratios along with their weights calculated from company’s data available in their annual 10k report. It uses the data on multiple corporate income and balance sheet items. The coefficients used as weights were projected by identifying a group of firms declared bankruptcy and then gathered a matched sample of survived firms with matching the industry type and size calculated on the basis of assets. The formula of Altman Z-score is given below:
Original Public Firms Altman Z-Score formula:
1,2 x (Working Capital / Total Assets)
1,4 x (Retained Earnings / Total Assets)
3,3 x (Earnings Before Interest and Taxes / Total Assets)
0,6 x (Market Value of Equity / Total Liabilities)
0,999 x (Net Sales / Total Assets)
= Altman Z-Score
It is generally believed that the score less than 1.8 shows there is a chance of bankruptcy for the company, score between 1.8-2.7 give an indication to the alarming situation that there is a probability for a company to go bankrupt within coming 2 operating years, score between 2.7-2.99 is an alert for a company to adopt caution, while score more than 3 shows favorable financial condition of the firm.
It is important to remember that neither Altman models nor any other models based on firm balance sheet are recommended for analyzing the financial companies. It is due to the opacity involved in the balance sheet of financial companies and because of frequently used off-balance sheet items. For assessing the probability of default of financial firms market based formulas are available like Merton Model but have limited predictive value due to their reliance on market data for predicting market event like decline.
What is an Altman Z-score
The Altman Z-score formula was developed by Edward I. Altman in 1968, for evaluating the financial performance of all type of firms including public, private, manufacturing and non-manufacturing. This formula approach is used by firms in different countries and contexts. Altman Z-score was mainly designed for only public manufacturing firms with assets amounting to more than $1 million but later on modifications were made by Altman.
Benefits of Altman Z-score
It can be used for predicting the bankruptcy and credit risk of any company. It is considered as easy measure of corporate defaults. Altman Z-score is useful for investors in deciding whether to buy or sell the stock of particular company on the basis of the financial strength of that particular company.