What Is the Altman Z-Score?
Let me explain the Altman Z-Score directly: it's a financial metric I use to gauge the bankruptcy risk for publicly traded companies. You calculate it by examining ratios tied to profitability, leverage, liquidity, and activity, which give you a clear view of the company's credit health and default potential.
Key Takeaways
- The Altman Z-Score formula helps determine if a company is at risk of bankruptcy.
- It incorporates ratios for profitability, leverage, liquidity, solvency, and activity.
- A score near 0 points to likely bankruptcy, while one near 3 shows strong financial standing.
Understanding the Altman Z-Score
You should know that the Altman Z-Score builds on the standard statistical Z-score, using five ratios from a company's 10-K report to forecast insolvency. Edward Altman created this in 1967, and over time, he's refined it—testing showed 82% to 94% accuracy across distressed firms from 1969 to 1999.
In 2012, he introduced the Altman Z-Score Plus for evaluating public, private, manufacturing, non-manufacturing, U.S., and international companies. This version is reliable for assessing corporate credit risk, and I find it essential for that purpose.
How to Calculate the Altman Z-Score
Here's how you compute it: the formula is Z = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E, where A is working capital over total assets, B is retained earnings over total assets, C is earnings before interest and tax over total assets, D is market value of equity over total liabilities, and E is sales over total assets.
If the score dips below 1.8, bankruptcy is probable; above 3, it's unlikely. As an investor, you might buy stocks with scores near 3 and sell those near 1.8. Recently, Altman noted that scores closer to 0 are the real red flag for financial trouble.
The 2008 Financial Crisis
Looking back, in 2007, asset-backed securities had inflated ratings, but the Altman Z-Score revealed growing risks. The median score was 1.81, akin to a B rating, meaning half the companies were distressed and bankruptcy-prone.
This led Altman to predict a credit market crisis from defaults, though it started with mortgage-backed securities. By 2009, corporate defaults hit near-record highs, confirming the score's foresight.
How Should an Investor Interpret the Altman Z-Score?
You can use the Altman Z-Score Plus to assess credit risk: below 1.8 means bankruptcy risk, above 3 means safety. Consider buying if it's near 3 and selling if near 1.8—or even closer to 0, per Altman's latest insights.
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