What is Your Company's Altman's Z Score?

What is Your Company's Altman's Z Score?

A fundamental step in determining the health of a company is the analysis of a company's historical financial statements. Historical data analysis provides a picture of the financial health of a business and a roadmap outlining the direction the business is heading. An integral part of historical analysis is the use of financial ratios. Financial ratios are analytical tools applied to financial data, which are used to identify positive and negative trends, strengths and weaknesses, investment attributes, and other trends, which measure the viability of a company's business.

Ratio analysis is typically used to measure a firm's liquidity, leverage, activity, profitability and growth. No single ratio calculation can provide a meaningful picture of a firm's financial condition. This article will focus on a model, which captures the predictive viability of a firm's financial health by using a combination of financial ratios that ultimately predicts a score, which can be used to determine the financial health of a company.

In 1968, Professor Edward Altman of the New York University School of Business developed what is known today as the "Z-Score." The Z-Score is a statistical model that incorporates the use of five different ratios, which serve to predict the health of a firm. Professor Altman believed that selecting various financial ratios and applying a certain weight to each ratio could develop a meaningful prediction model. The model was developed by sampling 66 publicly traded manufacturing companies that all had assets in excess of $1 million. Professor Altman evaluated 22 different ratios that ultimately were reduced to five balance sheet and performance ratios, which were weighted by established coefficients that account for their importance.

The following calculation is used to arrive at the total Z-Score:

Z = 1.20(X1) + 1.40 (X2) +3.30(X3) +.60(X4) + .99(X5)

X1 = Working Capital / Total Assets

X2 = Retained Earnings / Total Assets

X3 = Earnings before Interest and Taxes / Total Assets

X4 = Market Value Equity / Book Value of Total Debt

X5 = Sales / Total Assets

Z = Overall Score

The above calculation represents the overall index for a publicly traded manufacturing company. The calculation would be modified for a privately held business by implementing book value of equity because the privately held company's stock is not publicly traded. The private company Z-Score calculation would be calculated as follows:

Z = .717(X1) + .847(X2) + 3.107(X3) + .420(X4) + .998(X5)

Professor Altman further modified the formula for non-manufacturing companies by eliminating X5 (sales / total assets) due to the fact that sales / total assets can vary from industry to industry. The non-manufacturing company Z-Score would be calculated as follows:

Z = 6.56(X1) + 3.26(X2) + 6.72(X3) + 1.05(X4)

There is a different interpretation for each model. Professor Altman concluded that a Z-Score in the unhealthy category meant a company had the risk of going bankrupt, whereas a Z-Score in the healthy category represented a stable healthy company. Those companies that were in the gray area were considered misclassified.

Public Companies:
1.81 Unhealthy
1.81 - 2.99 Gray Area
2.99 Healthy

Private Companies:
1.23 Unhealthy
1.23 - 2.90 Gray Area
2.90 Healthy

Non-manufacturing Companies:
1.0 Unhealthy
 1.11 - 2.60 Gray Area ;
2.6 Healthy

The Z-Score is used by financial professionals, consultants, bankers, investors and various courts of law to measure a company's viability as an ongoing entity. Predictive models and ratio analysis are useful tools in measuring the health of a subject company. It should be noted that not every model is without shortcomings. First, ratio analysis is only as good as the underlying account data, which can be subject to manipulation. Additionally, ratio calculations can produce erroneous values when abnormal data is used.

The Z-Score is one way to provide a measure of a company's stability and its ability to function as a going concern. Many predictive models like the Z-Score provide credibility to the process. However, the Z-Score is just one method of predicting financial health and should not be the sole basis of evaluation. First hand knowledge of the operations and management are an integral part of the overall analysis necessary to come to any formal conclusions related to the final conclusion.


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