Z-Score
(E. Altman)
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What is the Z-score (E. Altman)?
The Z-Score, also known as Altman's Z-Factor, represents an evaluative model designed for companies, serving as a creditworthiness assessment tool. It quantifies the probability of bankruptcy for a publicly traded production company. Consequently, an investor can glean insights into a company's vulnerability to insolvency through the Z-sore. Derived from statistical Z-scores, this model forms a fundamental component of credit ratings. Broadly, it leverages a company's profitability, indebtedness, liquidity, solvency, and activity to forecast the likelihood of insolvency. The determination of the Z-score rests on diverse financial indicators, each carrying weighted significance.
Developed by Edward Altman, a financial professor at NYU Stern, in 1967, the Z-score underwent thorough testing. Between 1969 and 1975, Altman scrutinized 86 companies, followed by 110 from 1976 to 1995, and subsequently 120 from 1996 to 1999, yielding an accuracy range of 82% to 94% for the Altman Z-Score. In 2012, an updated version, the Altman Z-Score Plus, was introduced, encompassing both public and private entities, manufacturing and non-manufacturing firms, as well as American and non-American companies.
Nevertheless, the method presents
drawbacks. For instance, its efficacy diminishes significantly when applied to
young companies due to the complex interpretation of financial indicators for such enterprises. Young firms typically exhibit minimal profits, rendering the assessment less informative. Additionally, the model
does not hinge on cash flows, thus a high Altman Z-Score does not signify a company's ability to generate cash flows. Yet, cash flows bear significance concerning a company's solvency.
The Calculation of the Z-Score
As previously mentioned, the Altman Z-Score calculation hinges on five financial metrics, each weighted by specific factors. The formula for computing the Altman Z-Score is as follows:
Altman Z-Score = 1,2*A + 1,4*B + 3,3*C + 0,6*D + 1,0*E
where:
A = Working Capital / Total Assets
B = Retained Earnings / Total Assets
C = EBIT (Earnings Before Interest and Taxes) / Total Assets
D = Market Capitalization / Total Liabilities
E = Revenue / Total Assets
Originally, a value below 1.8 suggested a high likelihood of a company going bankrupt, while companies with a score above 3 were less likely to face bankruptcy. Investors, therefore, may consider buying stocks when the Altman Z-Score approaches 3 and selling or short-selling stocks when it nears 1.8. However, recent insights have indicated that a Z-Score of 0 serves as an early indication of financial distress. Consequently, a score ranging between 0 and 1.8 points signifies high risk, 1.8 to 3 points indicate moderate risk, while a score of 3 or higher signifies low risk.
The Financial Metrics in the Z-Score
The Z-score relies on five key financial metrics, each elucidated below:
- Working Capital / Total Assets: Working capital is derived from current assets minus short-term liabilities. It represents the capital employed in day-to-day operations. Inadequate working capital could imply an inability to cover production costs and meet short-term obligations. Conversely, excessive working capital might indicate inefficient allocation, such as high inventory levels, potentially diverting funds that could have been invested more profitably elsewhere.
- Retained Earnings / Total Assets: Retained earnings constitute a portion of capital company reserves, positively impacting solvency. Higher retained earnings signify greater profitability and financial strength.
- EBIT (Earnings Before Interest and Taxes) / Total Assets: This metric measures a company's productivity by indicating the profitability generated per unit of capital. It reflects the earning capacity crucial for meeting both debt obligations and interest payments, thereby influencing a company's solvency.
- Market Value of Equity / Total Liabilities: The market value of equity (market capitalization) represents the maximum liability a company holds. In the event of insolvency, liabilities must be settled. This can occur if the market value of equity exceeds total liabilities.
- Revenue / Total Assets: This metric signifies the revenue generated per unit of capital employed. While not all revenue translates to profit, a high revenue-to-assets ratio indicates market positioning and production efficiency.
These metrics serve as fundamental indicators within Z-score, shedding light on various facets of a company's financial health and solvency.
The Z-Score and the Financial Crisis of 2008
The calculation of the Altman Z-Score in 2007 indicated an increase in the likelihood of insolvency for companies. At that time, the median Altman Z-Score stood at 1.81, suggesting a crisis rooted in companies facing insolvency. However, this was not the origin of the financial crisis but rather mortgage-backed securities. Nevertheless, in 2009, there were the second-highest defaults in the history of corporate payments.
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