The Altman Z-score is a combination of five weighted business ratios that is used to estimate the likelihood of financial distress. For value investors, the score is a great time-saving tool to help calculate a company’s financial longevity and assess liquidity. However, the Z-score is all too often overlooked in favor of other simpler metrics such as basic gearing and debt ratios, although the score is relatively easy to calculate if you know how.
Z-Score: A useful ratio
First invented and developed in 1968 by Edward I. Altman, an assistant professor of finance at New York University, the Z-score is a quantitative balance sheet method of determining a company’s financial health that draws on the results of five different calculations to arrive at an overall evaluation of the company’s financial stability.
The accuracy of the model, rigorously tested over more than 30 years after its development is a testament to how reliable it can be.
In its initial tests, the Altman Z-Score was found to be 72% accurate in predicting bankruptcy two years before the event. But over the next 31 years, in the various white papers and real-world examples, the model was found to be 80% to 90% accurate in predicting bankruptcy one year before the event.
Unfortunately, due to the way the ratio is calculated, it is practically useless for financial companies. The Z-score uses various metrics, (described below) which compare levels of indebtedness to asset values and as most financial companies frequently push liabilities and assets off balance sheet, the ratio is not sufficiently capable. What’s more, I should state that the Z-score is not intended to predict when a firm will actually file for bankruptcy protection; instead it should be used more as an indicator of when a business is likely to file for bankruptcy compared to other firms that have gone down a similar path.
Calculating the ratio
So, how is the ratio calculated? As mentioned above, the Z-score is calculated using the sum of five different ratios weighted according to importance:
1. T1 = Working Capital / Total Assets. A measure of liquid assets. A firm heading for financial difficulties will usually experience shrinking liquidity.
2. T2 = Retained Earnings / Total Assets. A measure of cumulative profitability. Shrinking profitability is a warning sign.
3. T3 = Earnings Before Interest and Taxes / Total Assets. A measure of how productive a company is relative to its asset base.
4. T4 = Market Value of Equity / Book Value of Total Liabilities. A test of how far the company’s assets can decline before insolvency.
5. T5 = Sales/ Total Assets. Asset turnover. How effectively the firm uses its assets to generate sales.
After the figures to all of the above sums are known, the score is calculated with the following formula:
1.2*T1 + 1.4*T2 + 3.3*T3 + 0.6*T4 + 1.0*T5
If the answer to the above equation is less than three, the company may be heading for financial distress. A ratio between 2.99 and 1.8 implies that the firm has a high risk of facing financial troubles within the next two years. Meanwhile, a ratio of 1.8 or less indicates a high probability of financial stress within two years and might be wise to avoid the company. Of course, these figures are not set in stone, and further research will answer the question of whether the company should be avoided altogether, viewed with caution or purchased with a speculative frame of mind.
Based on the above formula, I’ve calculated the Z-score for some of the most indebted large-cap U.S. companies. In order of riskiness, below are 10 of the lowest scoring Z-score large-caps:
Disclosure: The author owns no shares of stocks mentioned within this article.