## Definition of Altman Z-Score

The Altman Z-Score is used to calculate the probability and likelihood of a business being bankrupt in the coming two years. From an investor’s perspective, Altman Z-Score reflects the relative safety of the given investment of the company. The Altman Z-Score is calculated using components in the financial statements of the company, which help investors (and other stakeholders) to get an idea regarding the financial position of the company.

By checking for chances of bankruptcy of a particular company, the Going Concern Accounting principle is further double-checked. It is important for organizations to realize the importance of checking these measures so that there is reasonable assurance that the company is a going concern at least for the foreseeable future.

## Formula for Altman Z-Score

Altman Z-Score is calculated using the following formula:

Altman Z-Score = 1.2A x 1.4B x 3.3C x 0.6D x 0.99E

In the letters above, the following holds true:

A = Working Capital / Total Assets (In order to measure the relative amount of liquid assets)

B = Retained Earnings / Total Assets (In order to determine cumulative profitability)

C = Earnings before interest and tax / Total Assets (In order to measure earnings after discounting leverage, and taxes)

D = Market Value of Equity / Book Value of Total Liabilities (In order to incorporate the impact of the decline in the market value of the company’s shares)

E = Sales / Total Assets (In order to measure the total asset turnover of the company)

## Explanation of Altman Z-Score

As mentioned earlier, it can be seen that Altman Z-Score is made up of the 5 different ratios:

- Working Capital / Total Assets

Working Capital is defined as the difference between current assets and current liabilities of the company. Working Capital indicates the ability of the company to meet its day-to-day expenses. This ratio is used in order to determine the ability of the company to generate profits using the assets they have on hand.

- Retained Earnings / Total Assets

This ratio shows the Retained Earnings alongside the Total Assets of the company. A lower ratio reflects that the fact that the company finances its expenditures from borrowed funds, and not retained earnings. Therefore, it increases the probability of the company using bankrupt.

On the other hand, higher retained earnings imply that the company uses retained earnings to fund capital expenditures, and hence this is a positive insight for investors.

- Earnings Before Interest and Taxes / Total Assets

This is a measure of the company’s profitability, with respect to the total assets that they have. This shows the ability of the company to generate enough revenues in the foreseeable future, with the given resources.

- Market Value of Equity / Total Liabilities

The Market Value of Equity / Total Liabilities is indicative of the degree to which a market value would decline in the case where the company declares bankruptcy – particularly when liabilities exceed the assets of the company. A higher ratio indicates higher confidence in the financial strength of the company.

- Sales / Total Assets

The Sales to Total Assets Ratio shows how efficiently the management is able to utilize its assets in order to generate revenues with the given asset spread. A higher ratio is a good indication for the investors, whereas a lower ratio is not considered to be a good indication.

## Interpretation of the Altman Z-Score

Altman Z-Score is a numerical figure, which has implications depending on the range it lies in.

An Altman Z-Score of 2.99 implies that the entity for which the score has been calculated is safe from the risk of bankruptcy.

An Altman Z-Score less than 1.81 implies that the entity for which the score has been calculated has a considerable exposure towards bankruptcy.

If the score lies between 2.99 and 1.81, this is indicative of the possible red flags, which must be taken into consideration by the company. These possible problems should be dealt with in order to mitigate the risk of bankruptcy altogether.

Therefore, this implies that higher Z-Scores are safer (i.e. indicate less exposure towards bankruptcy), whereas lower Z-Scores are considered to be risky.

The model of Altman Z-Score has historically proven to be highly effective in determining the actual course of action for companies, primarily because of the reason that it gives a much-needed insight to the investors regarding their investment decisions in the company.

## Considerations of Altman Z-Score

The Altman Z-Score scoring system was initially designed in order to incorporate manufacturing concerns that have assets greater than or equal to $1 Million or more. Since this was considered to be a targeted nature of the model itself, it was specified to be applicable towards other organizations.

From an investor’s, prospective corporate credit risk can be evaluated using this module. Investors normally prefer purchasing stocks and investments in companies that have an Altman Z-Score closer to 3. Similarly, they might choose to sell the stock if the Altman Z-Score is closer to 1.8 since that is not a good indication for the company, and hence, for the investors.

## Example of Altman Z-Score

The concept and calculation of Altman Z-Score are illustrated in the following illustration:

*An investor is faced with two different investment options they can choose from. The summaries of financial details of both these organizations are given below:*

*Company A*

Particular | Amount |

Working Capital | $1,000,000 |

Retained Earnings | $500,000 |

Earnings Before Interest and Taxes | $750,000 |

Market Value of Equity | $1,500,000 |

Sales | $1,200,000 |

Total Assets | $1,000,000 |

Total Liabilities | $1,000,000 |

For Company A, the Altman Z-Score is going to be calculated as follows:

Altman Z-Score = 1.2A x 1.4B x 3.3C x 0.6D x 0.99E

A = Working Capital / Total Assets = $1,000,000 / $1,000,000 = 1

B = Retained Earnings / Total Assets = $500,000 / $1,000,000 = 0.5

C = Earnings before interest and tax / Total Assets = $750,000 / $1,000,000 = 0.75

D = Market Value of Equity / Book Value of Total Liabilities = $1,500,000 / $1,000,000 = 1.5

E = Sales / Total Assets = $1,200,000 / $1,000,000 = 1.2

Therefore, Altman Z-Score will be:

Altman Z-Score = 1.2(1) x 1.4(0.5) x 3.3(0.75) x 0.6(1.5) x 0.9(1.2) = 2.22

On the other hand, Company B has the following data:

Particular | Amount |

Working Capital | $2,000,000 |

Retained Earnings | $1,000,000 |

Earnings Before Interest and Taxes | $950,000 |

Market Value of Equity | $1,800,000 |

Sales | $1,500,000 |

Total Assets | $1,200,000 |

Total Liabilities | $1,500,000 |

Depending on the information presented above, Altman Z-Score is going to be calculated as follows:

Altman Z-Score = 1.2A x 1.4B x 3.3C x 0.6D x 0.99E

A = Working Capital / Total Assets = $2,000,000 / $1,200,000 = 1.67

B = Retained Earnings / Total Assets = $950,000 / $1,200,000 = 0.83

C = Earnings before interest and tax / Total Assets = $650,000 / $1,200,000 = 0.54

D = Market Value of Equity / Book Value of Total Liabilities = $1,800,000 / $1,500,000 = 1.2

E = Sales / Total Assets = $1,500,000 / $1,200,000 = 1.25

Therefore, Altman Z-Score will be:

Altman Z-Score = 1.2(1.67) x 1.4(0.83) x 3.3(0.54) x 0.6(1.2) x 0.9(1.25) = 3.7

Based on the information presented above, it can be seen that Altman Z-Score for both the companies corresponds to 2.2 and 3.7 respectively.

Therefore, from an investor’s perspective, the Altman Z-Score shows Company B is a relatively safer option for investors to invest in.

It must also be noted that Altman Z-Score is not the *only* criteria that are used by investors to decide which share to purchase. In fact, it is one of the many considerations that are accounted for when an investment decision is made.