Altman Z-Score

• It is a statistical tool used to measure the likelihood that a company will go bankrupt dvised by Edward Altman, the New York University professor in the 1960s.
• It is a multivariate analysis to the mix of traditional ratio-analysis techniques (e.g. current and quick ratio), and able 
• to consider  the effects of several ratios on the "predictiveness" of his bankruptcy model, 
• to consider how those ratios affected each other's usefulness in the model.
• Altman evaluated 66 companies (half of which had filed for bankruptcy between 1946 and 1965) and started out with 22 ratios classified into five categories (liquidity, profitability, leverage, solvency and activity) but eventually narrowed it down to five ratios.
• X1 = Working Capital / Total Assets
• X2 = Retained Earnings / Total Assets
• X3 = EBIT / Total Assets
• X4 = Market Value of Equity / Book value of Total Liabilities
• X5 = Sales / Total Assets
• Altman re-evaluated his methods by examning 
• 86 distressed companies from 1969 to 1975
• 110 bankrupt companies from 1976 to 1995
• 120 brankrupt companies from 1196 to 1999
• Altman Z-Score, Z = 1.2*X1 + 1.4*X2 + 3.3*X3 + 0.6*X4 + 1.0*X5
• X1: Working Capital / Total Assets
• Working capital = current asset - current liabilities 
• Valuable liquidity measure of the net liquid assets of the firm realtive to the total capitalization 
• Liquidity and size characteristics are explicitly considered.
• A firm experiencing consistent operating losses will have shrinking current assets in relation to totla asset
• X2: Retained Earnings / Total Assets
• RE = Total Amount of reinvested earnings / losses of a firm over its entire life.
• The age of firm is implicitly considered in this ratio - a relatively young firm will probably show a low X2 ratio (as it has not enought time to accumulate profit)
• Young firm is discriminated in this analysis? Its chance of going bankrupt is relatively hire than older firm. (this is precisely the situation on the real world)
• It also measure the leverage of the a firm - firm with highe RE relative to TA financed their assets through retention of profits and have not utilized as much debt.
• X3: EBIT / Total Assets
• A firm ultimate existence is based on the earning power of its assets. X3 measure the true productivity of the firm's assets - independent of any tax or leverage factors
• Insolvency in a bankrupt sense occurs when the total liabilities exceed a fair valuation of the firm's assets with value determined by the earning power of the assets. 
• X4: Market Value of Equity / Book value of Total Liabilities
• Equity = all shares of stock (preferred and commont)
• This measure show how much the firm's assets can decline in value before the liabilities exceed the assets and the firm becomes insolvent.
• It appear to be more effective predictorof bankruptcy than Net Worth / Total Debt [Book value]
• X5: Sales / Total Assets
• It illustrating the sales generating ability of the firm's assets.
• It measure management's capacity in dealing with competitive conditions.
• It is useful predictor when used with the other four.
• The interpretation of Altman Z-Score
•  > 3.0 = The company is "Safe" based on the financial figures only.
• 2.7 - 2.99 = "On Alert" 
• 1.8 - 2.7 = Good chance of the company going bankrupt within 2 yers of operations from the date of financial figure given.
• < 1.8 = Probability of Financial Catastrophe is Very High
• If Z close to or below 3, some serious Due Diligence on the company in question before even considering investing.
• Z Score was between 82% and 94% accurate 
• 'Garbage in, Garbage out' motto applies - if the company financials are misleading or incorrect, Z Score will be, too.

References:-

• Altman Z-Score  kcchongnz (private)
• Pitroski F-Score, the Altman Z-Score and the Beneish M-Score kcchongnz (private)
• Buying bargains on the mend kcchongnz (private)