Altman Z-score definition
Estimation of the possibility that a company will go bankrupt within a given time.
What is Altman Z-score?
Altman Z-score estimates the probability that a company will go bankrupt or become insolvent. The calculation is based on five different financial ratios. Each ratio is used for analyzing specific parts of the company's performance. The score for a company is calculated for the upcoming two years. It predicts the possibility that a company will go bankrupt in the next two years.
Altman Z-score can be quickly estimated by investors because the required information is readily available and can be found in the company's financial statements and reports.
Altman Z-score explained
The score is calculated on the basis of different financial ratios. These ratios capture the financial health of the company through different areas. The obtained value for each ratio is multiplied by the relevant coefficient. The sum is the value for Altman Z-score. Therefore, the Z-score is calculated as follows:
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 tax / total assets
D - market value of equity / total liabilities
E - sales / total assets
Each component of the formula has its own purpose. The first component "A" refers to the liquid assets. The component "B" considers profitability, while the third component excludes the effect of taxation and interest. "D" accounts for a possible decline in the market value of a company, and "E" is an estimation for the asset's turnover.
An Altman Z-score below 1.8 indicates that the company could be faced with bankruptcy in the future. Companies with a score above 3 will likely not go bankrupt. Investors could buy a stock with a Z-score value around 3, while they can sell stocks with a score of 1.8 or below.
The Altman Z-score values can be summarized as follows:
Z-score below 1.8 indicates a company with a higher probability for bankruptcy;
Z-score in the range from 1.81 to 2.99 indicates the company is in the caution zone;
Z-score above 3 indicates a company with good financial health.
Altman Z-score meaning
The Altman Z-score evaluates the financial situation of the company, based on items found on the balance sheet and the income statement. This measure is used by investors in their decision whether or not to invest in a company. It could also be an indicator that it is time for shares from a specific company to be sold if the Altman Z-score identified a higher probability for bankruptcy.