Altman Z score

Altman Z score
See also
Doubtful account Optimal capital structure Book-to-Market Ratio SPACE method Capital market theories Total capitalization Du Pont analysis Standard price Gordon Growth Model

Altman Z score is a model that determines the financial condition of an enterprise. The Altman model is a multidimensional approach based on ratio-level and qualitative indicators. These values are combined and weighted to obtain the measure of credit risk assessment. It best distinguishes between companies that fail and those in good financial condition. The z score model was constructed using multiple discriminant analyzes, a multi-dimensional technique that analyzes a set of variables to maximize the variance between groups while minimizing variance within groups. In a bank, when applying for a loan based on an evaluation based on the z-score model, companies with a weak financial position could be rejected or subjected to increased control if their results were lower than the critical benchmark. Although the Altman model was created in 1968, it is still used to analyze US-listed companies.

Use of the model

Edward Altman is a New York professor who, based on statistical methods, created a model showing the financial condition of the company. It is used for diagnostics of listed companies. Thanks to this model you can check the company quickly and uncomplicatedly. Many institutions like it use:

• banks and financial institutions to assess initial creditworthiness
• investors who based on it decide whether to sell shares of an enterprise threatened with bankruptcy
• company managers who are to assess its financial position
• suppliers and recipients to rate their customers
• auditors for financial statements
• insurers

Model description

Initially, Professor Altman selected 22 indicators thanks to which it was possible to assess the company's financial situation. From this wide list, 5 indicators have been selected that best show the risk of bankruptcy of the enterprise. In the multidimensional discriminant analysis process, appropriate coefficients were selected for them. The final version of the model took the following form:

${Z=1,2X1+1,4X2+3,3X3+0,6X4+0,999X5}$

• Z - total result
• X1 = (Working capital / Total assets) is a measure of the company's liquidity net assets in relation to its entire capitalization. Working capital defined as the difference between current assets and current liabilities.
• X2 = (Retained earnings / Assets) - Responsible for measuring the profitability of accumulated retained earnings in the enterprise.
• X3 = (EBIT / Assets) - This indicator shows the real productivity of the company's assets, independent of taxes and interest.
• X4 = (Market value of the enterprise / Accounting value of the debt) - It measures the amount of financial support in the enterprise.
• X5 = (Sales revenues) / Assets - An indicator showing the degree of utilization or return on assets.

Bankruptcy qualification according to Edward Altman

indicator value	bankruptcy threat level
1,8 or less	very high
1,81 - 2,99	indefinite
3,0 or more	little

The table shows that enterprises with a rate of 3.0 or higher are in a very good financial position, while companies with a score of 1.8 or less are close to bankruptcy.

Examples of Altman Z score

• An example of an Altman Z score is a company that has a debt to equity ratio of 1.5 and a current ratio of 1.2. This company would have a z-score of 1.15, which is within the acceptable range and indicates that the company is in good financial condition.
• Another example of an Altman Z score is a company with a debt to equity ratio of 4.0 and a current ratio of 0.8. This company would have a z-score of -1.18, which is below the acceptable range and indicates that the company is in a weak financial position.
• Lastly, an example of an Altman Z score is a company with a debt to equity ratio of 2.0 and a current ratio of 1.5. This company would have a z-score of 0.71, which is within the acceptable range and indicates that the company is in a relatively good financial position.

Advantages of Altman Z score

The Altman Z score is a useful tool to assess the financial condition of an enterprise. It has several advantages, including:

• It is an effective way to differentiate between companies that fail and those in good financial condition.
• It is an objective and quantitative approach that takes into account multiple factors.
• It uses a combination of ratio-level and qualitative indicators for assessment.
• It is based on a multi-dimensional approach, which maximizes the variance between groups while minimizing variance within groups.
• It is simple to use and understand.
• It is still used to analyze US-listed companies, even though it was developed in 1968.

Limitations of Altman Z score

The Altman Z score has some important limitations that must be taken into consideration when using it to assess the financial condition of companies. These limitations include:

• It is not applicable to companies that are not publicly traded.
• It does not take into account the industry-specific factors that can influence the financial condition of a company.
• It does not account for any off-balance-sheet liabilities that may exist.
• It does not take into account the macroeconomic environment or the political and social factors that may influence the company's performance.
• It does not consider the age of the company, which could influence its financial condition.
• It does not capture the changes in the accounting policies or the level of risk that a company may be taking.
• It does not take into account the quality of management or the level of corporate governance within a company.
• It does not consider any qualitative factors that could impact the performance of a company.

Other approaches related to Altman Z score

• Introduction: Aside from Altman Z score, there are other approaches used to evaluate the financial condition of a company.
• Financial Statement Analysis: This approach involves analyzing the financial statements of a company, such as the balance sheet, income statement, and cash flow statement, to gain insights into a company's performance and financial health.
• Cash Flow Analysis: This approach is used to evaluate the liquidity of a company by analyzing its cash inflows and outflows from operating, investing and financing activities.
• Business Ratios Analysis: This approach involves analyzing different financial ratios, such as the current ratio, debt-to-equity ratio, and return on assets, to assess the financial condition of a company.
• Credit Risk Analysis: This approach involves assessing a company's creditworthiness by analyzing its credit history, financial statements, and other relevant factors.

In summary, there are various approaches that can be used to evaluate the financial condition of a company, such as financial statement analysis, cash flow analysis, business ratios analysis, and credit risk analysis, in addition to the Altman Z score model.

References

• Caouette J. (ed.)(1998), Managing credit risk: the next great financial challenge, John Wiley & Sons, USA
• Johnson R. (2013), Debt markets and analysis, John Wiley $ Sons, USA
• Wahlen J. (ed.)(2010), Financial reporting, financial statement analysis and valuation: a strategic perspective, Cengage Learning, USA

Footnotes

Author: Izabela Szmalec