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.

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