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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 be calculated from data found on a company's annual 10K report. It uses profitability, leverage, liquidity, solvency and activity to predict whether a company has a high degree of probability of being insolvent.

BREAKING DOWN 'Altman Z-Score'

The Altman Z-score is calculated as follows:

Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where:

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

NYU Stern Finance Professor Edward Altman, developed the Altman Z-score formula in 1967, and it was published in 1968. In 2012, he released an updated version called the Altman Z-score Plus that can be used to evaluate public and private companies, manufacturing and nonmanufacturing companies, and U.S. and non-U.S. companies. The Altman Z-score Plus can be used to evaluate corporate credit risk.

A score below 1.8 means the company is probably 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 particular stock if they're concerned about the underlying company's 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.

Altman Z-Scores and the Financial Crisis

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 B. This indicated that 50% of the firms should have been rated lower, and they were highly distressed and had a high probability of becoming bankrupt.

Altman's calculations led him to believe that 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 (MBS). However, corporations soon defaulted in 2009 at the second-highest rate in history.

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