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With a global pandemic disrupting the economy, investors should remember to invest their hard-earned savings only in financially strong companies that can handle a crisis without getting wiped out.
In this article, we'll discuss how to evaluate the financial strength of a business using the Altman Z-Score, a popular credit-risk indicator that can help investors spot companies with high bankruptcy risk.
What Is The Altman Z-Score?
The Altman Z-Score is a credit-risk indicator that estimates the company's risk of going bankrupt within the next two years using metrics derived from its income statement and balance sheet. The score was first published in a 1968 paper by Edward Altman, a now renowned Finance professor at NYU's Stern School of Business.
An Altman Z-Score greater than 2.99 indicates a company is in the safe zone. A score between 1.81 and 2.99 indicates that the business is in the gray zone, while a score below 1.81 is considered to be in the distress zone.
How To Calculate The Altman Z-Score: Formula Explained
Here's the Altman Z-Score Formula:
Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
A = Working Capital / Total Assets
B = Retained Earnings / Total Assets
C = Earnings Before Interest And Taxes / Total Assets
D = Market Value Of Equity / Book Value Of Total Liabilities
E = Sales / Total Assets
Let's break down each formula's component:
- Working Capital / Total Assets measures the liquidity of the company's assets with respect to its size.
- Retained Earnings / Total Assets is used to indicate past profitability, company age, and profit potential.
- Earnings Before Interest and Taxes / Total Assets measures the current profitability and asset efficiency of the company.
- Market Capitalization / Total Liabilities measures the amount of leverage based on the company's future profit potential and the value ascribed to its equity in the current economic environment.
- Total Revenue / Total Assets is an additional measure of current profitability and asset efficiency.
For non-U.S. and financial institutions, a modified version of the formula called Z"-Score is used.
Z" = 6.56A + 3.26B + 6.72C + 1.05D + 3.25
A = Working Capital / Total Assets
B = Retained Earnings / Total Assets
C = Operating Income / Total Assets
D = Book Value of Equity / Book Value of Liabilities
In this case, an Altman Z-Score greater than 2.6 indicates the company is in the safe zone. A score between 1.1 and 2.6 indicates the business is in the gray zone, while a score below 1.1 is considered in the distress zone.
Altman Z-Score Example Calculation
Let's walk through an example – we can use the aforementioned formula to calculate Apple's (AAPL) Altman Z-Score.
Using the Finbox data explorer, we find the values of the formula's components:
We can now calculate Apple's FY and LTM Altman Z-Score:
Apple's LTM Altman Z-Score of 6.68 suggests an extremely low probability that the company will go bankrupt in the next two years.
Altman Z-Score Calculator
You can calculate the Altman Z-Score for every single company in the world using this template. You just have to enter the required data of the company whose ratio you want to calculate, and the model will do everything automatically.
You can use the Finbox Data Explorer to get all the data you need for 100,000+ companies worldwide. Here's a preview of Finbox's Altman Z-Score Calculator:
Altman Z-Score: Sector Benchmarks
As of August 19, 2020, the sectors with the highest Altman Z-Score are information technology, industrials, and consumer staples. Financials, communication services, and energy are the sectors with the lowest Z-Score.
What Is A Good Altman Z-Score?
If you try searching for an appropriate Altman Z-Score on Google, you will probably find that a company with a Z-Score greater than 2.99 is considered to be in the safe zone, but this is only partially correct.
Important: The Altman Z-score is designed for evaluating the likelihood of bankruptcy for publicly-traded manufacturing companies. Using the original guidance for a different type of company would be a mistake.
For example, firms operating in the IT sector have an average Altman Z-Score of 3.83. Anything below that should be a warning sign for investors. At the same time, firms operating in the healthcare sector have an average Z-Score of 1.20, so you shouldn't panic if a healthcare firm has a Z-Score lower than 1.81.
As a rule of thumb, a good Altman Z-Score is in line with the sector average. When a company has a Z-Score that is too low compared to others in the same sector, you should flag it and do more research!
