What Is the Altman Z-Score?
The Altman Z-score is the output of a credit-strength test that gauges a publicly-traded manufacturing company's likelihood of bankruptcy. The Altman Z-score is based on five financial ratios that can calculate from data found on a company's annual 10-K report. It uses profitability, leverage, liquidity, solvency, and activity to predict whether a company has a high probability of becoming insolvent.
- The Altman Z-score is a formula for determining whether a company, notably in the manufacturing space, is headed for bankruptcy.
- The formula takes into account profitability, leverage, liquidity, solvency, and activity ratios.
- An Altman Z-score close to 1.8 suggests a company might be headed for bankruptcy, while a score closer to 3 suggests a company is in solid financial positioning.
How the Altman Z-Score Works
One can calculate the Altman Z-score 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
A score below 1.8 means it's likely the company is headed for bankruptcy, while companies with scores above 3 are not likely to go bankrupt. Investors can use Altman Z-scores to determine whether they should buy or sell a stock if they're concerned about the company's underlying financial strength. Investors may consider purchasing a stock if its Altman Z-Score value is closer to 3 and selling or shorting a stock if the value is closer to 1.8.
In 2007, the credit ratings of specific asset-related securities had been rated higher than they should have been. The Altman Z-score indicated that the companies' risks were increasing significantly and may have been heading for bankruptcy.
Altman calculated that the median Altman Z-score of companies in 2007 was 1.81. These companies' credit ratings were equivalent to a B. This indicated that 50% of the firms should have had lower ratings, were highly distressed and had a high probability of becoming bankrupt.
Altman's calculations led him to believe a crisis would occur and there would be a meltdown in the credit market. Altman believed the crisis would stem from corporate defaults, but the meltdown began with mortgage-backed securities. However, corporations soon defaulted in 2009 at the second-highest rate in history.
History of the Altman Z-Score
NYU Stern Finance Professor Edward Altman developed the Altman Z-score formula in 1967, and it was published in 1968. Over the years, Altman has continued to revaluate his Z-score over the years. From 1969 until 1975, Altman looked at 86 companies in distress, then 110 from 1976 to 1995, and finally 120 from 1996 to 1999, finding that the Z-score had an accuracy of between 82% and 94%.
In 2012, he released an updated version called the Altman Z-score Plus that one can use to evaluate public and private companies, manufacturing and non-manufacturing companies, and U.S. and non-U.S. companies. One can use Altman Z-score Plus to evaluate corporate credit risk. The Altman Z-score has become a reliable measure of calculating credit risk.