There are two numbers I really like looking at when conducting financial analysis. One is the Piotroski F-Score, which I covered in a previous article, and the other is the Altman Z-score, which we will discuss in this article.
GuruFocus readers will already appreciate the usefulness of ratio analysis. An extension of ratio analysis is to identify a few ratios that highlight a particular aspect of a company and combine them to produce a single, “multivariate” ratio that is essentially a kind of weighted average of the components.
A whole body of academic research in finance has focused on identifying liquidity problems. By using ratios, we can identify companies that might prove an excess credit to lenders.
The Altman Z-score is one such useful multivariate. This composite ratio calculation was invented by Edward Altman from New York University, who is an expert on corporate bankruptcy, high yield bonds, distressed debt and credit risk analysis. The intention of the score is to assess the solvency of a particular company. Depending on the Z-score calculated by the formula, an assessment can be reached on the likelihood of a firm facing bankruptcy in the next couple of years. Given that equity gets wiped out before debt, equity holders would do well to keep an eye on a stock’s Z-score. Another way to look at it is that an equity is a credit, it is just that it is a credit for a lifetime.
Because the Z-score is derived from a combination of balance sheet and income statement items, it helps us understand the health of a company, much like taking the pulse of a human. It also lets us understand how efficiently a firm is being run.
The formula
The Altman Z-Score is derived as follows:
"Z = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E"
Each of the letters in the formula represents a different financial ratio:
A = working capital/total assets
B = retained earnings/total assets
C = earnings before interest and taxes/total assets
D = market value equity/book value of total liabilities
E = sales/total assets
Results
The results can be interpreted as follows:
Z-score < 1.81; bankruptcy is predicted to be possible, these firms will need a restructuring or recapitalization. The drivers are likely to be high fixed assets, low margins, excess debt and poor financial management. These are likely to be high beta stocks and so will fall hard in a correction. These stocks should be avoided by fundamentally driven investors and are the domain of distressed funds.
Z score > 1.81 but < 2.99; the position is unclear (i.e. a grey area).
Z score > 2.99; the company is safe with no risk of bankruptcy. These stocks are likely well-managed franchises - cash rich, high margins, long history of retained earnings, likely high price/book ratio and high goodwill. They are typically low beta stocks with strong return on equity of 15% or more.
The ratios A to E are useful individually, but taken together provide an insight into a company's solvency. Let's take a look at each of them in more detail.
A. Working capital/total assets: Working capital is calculated by deducting current liabilities from current assets. How well does a company manage its cash and inventory? The higher this ratio is, the greater the working capital, and thus the greater the balance sheet liquidity. The current ratio or quick ratio gives a similar measure of liquidity. High balance sheet liquidity lowers the bankruptcy risk.
B. Retained earnings/total assets: How profitable has the company been? The higher the level of retained earnings, the greater the "creditors' buffer" and thus the lower the bankruptcy risk.
C. Earnings before interest and taxes/total assets: How well does a company watch its costs? This is an indicator of profitability and efficiency. Making a reasonable return should make a business more able to meet the demands of creditors. Altman accords this ratio the highest weighting in his formula. A profitable business is more likely to survive going forward.
D. Market value equity/book value of total liabilities: How do the shareholders' investments in the company compare to the amount owed by the business? The greater the proportion of shareholders' equity, the lower the bankruptcy risk.
E. Sales/total assets: This is the asset turnover ratio, which is a measure of efficiency. How hard does a company push its assets? Are the assets of the business productive in generating revenue? Higher capital efficiency lowers bankruptcy risk.
Z-scores can also be used for macro investing. Investors who believe high inflation is around the corner may want to buy companies with bad Altman Z scores because high inflation, all else equal, is likely to put upward pressure on Z-scores, so bad companies can quickly see their scores rapidly increase as debt becomes easier to repay. Conversely, investors who see deflation will want to buy companies with high Altman Z scores, as a high score will give a company relatively more protection in this environment.
Real life example
Below, we'll take a look at Genus PLC (LSE:GNS, Financial), a biotechnology company and a 7.1% holding in Alexander Darwall’s European Opportunities Trust.
The Z-score indicates that the Genus plc’s financial position has changed from showing a very healthy position in 2019 to an even more healthy position for 2020's results. This improvement has been driven by a significant increase in the deleveraging of the business as shown by the market value of equity to total liabilities ratio improving from 5.41 to 6.35. Other ratios were little changed between the two years. Note, I used the "SUMPRODUCT" function in Excel to multiply the weights by the ratios for 2019 and 2020, respectively.
