Variables associated with Altman Z-Score
Let us look at the variables associated with Altman Z-Score:
- Market value: Market value stands for the total outstanding shares a company has.
- Book value: Found in the company balance sheet, the book value refers to the long and short-term debts. Typically, the reserves listed on the credit side of the balance sheet are not included in the company's book value.
- Total assets: Total assets include all the assets listed on the balance sheet. This includes cash and properties that require longer-term investments.
- Turnover: Turnover refers to the total sales that the company generates in a year. Turnover should be recorded in the same year as the profit before tax and interest.
- Total retained earnings: Total retained earnings refer to the cumulative profits earned in the past that have been reinvested in the company. Note that this does not account for taxes and dividends.
- Working capital: Working capital is the money used to fund the company's activities and must be available on short notice. To calculate the working capital, current short-term debts are subtracted from cash and cash equivalents.
Altman Z-Score formula and calculation
The Altman Z-Score formula for public manufacturing companies uses five different variables. Each of these variables is a ratio. Check out the Altman Z-Score formula and the meaning of each variable in it.
| Altman Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E |
Where:
A = Working capital ÷ Total assets
B = Retained earnings ÷ Total assets
C = EBIT ÷ Total assets
D = Equity market value ÷ Total liabilities
E = Sales ÷ Total assets
Example
To understand how the Altman Z-Score formula is used more clearly, let us discuss a hypothetical example. Consider the following details for a company.
Working capital = Rs. 5,00,000
Retained earnings = Rs. 3,00,000
EBIT = Rs. 2,50,000
Equity market value (aka market capitalisation) = Rs. 15,00,000
Sales = Rs. 30,00,000
Total assets = Rs. 20,00,000
Total liabilities = Rs. 10,00,000
Using the above values, here is what the five variables in the Altman Z-Score model will be:
| Variable |
Formula |
Calculation |
Value |
| A |
Working capital ÷ Total assets |
Rs. (5,00,000 ÷ 20,00,000) |
0.25 |
| B |
Retained earnings ÷ Total assets |
Rs. (3,00,000 ÷ 20,00,000) |
0.15 |
| C |
EBIT ÷ Total assets |
Rs. (2,50,000 ÷ 20,00,000) |
0.125 |
| D |
Equity market value ÷ Total liabilities |
Rs. (15,00,000 ÷ 10,00,000) |
1.5 |
| E |
Sales ÷ Total assets |
Rs. (30,00,000 ÷ 20,00,000) |
1.5 |
Putting the values of these variables in the Altman Z-Score formula, we get the following result.
Altman Z-Score:
= 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
= 1.2(0.25) + 1.4(0.15) + 3.3(0.125) + 0.6(1.5) + 1.0(1.5)
= 0.3 + 0.21 + 0.4125 + 0.9 + 1.5
= 3.3225
Interpreting the Altman Z-Score
Once you calculate the Altman Z-Score, you need to interpret it correctly. The risk of a company going bankrupt depends on the score that you get as a result. Here is what different ranges of the Altman Z-Score mean for a public manufacturing company.
| Altman Z-Score |
What it means |
| Below 1.81 |
The company is in financial distress, with a high possibility of bankruptcy. |
| 1.81 to 2.99 |
The company is in the financial grey area, with a moderate risk of bankruptcy. |
| More than 2.99 |
The company is financially safe, with a low possibility of bankruptcy. |
Variants of the Altman Z-Score
The Altman Score has tailored versions for different types of companies, including private manufacturing firms, non-manufacturing businesses in developed markets, and enterprises in emerging economies. Explore the distinct variants below.
1. Private manufacturing companies
The formula for the Altman Z-Score for manufacturing companies in the private sector is:
| Altman Z-Score = 0.717A + 0.847B + 3.107C + 0.42D + 0.998E |
Where:
A = (Current assets — current liabilities) ÷ Total assets
B = Retained earnings ÷ Total assets
C = EBIT ÷ Total assets
D = Equity book value ÷ Total liabilities
E = Sales ÷ Total assets
2. Non-manufacturing companies in a developed market
Here, the Altman Z-Score formula is modified as shown below:
| Altman Z-Score = 6.56A + 3.26B + 6.72C + 1.05D |
Where:
A = (Current assets — current liabilities) ÷ Total assets
B = Retained earnings ÷ Total assets
C = EBIT ÷ Total assets
D = Equity book value ÷ Total liabilities
3. Non-manufacturing companies in an emerging market
The Altman Z-Score formula for these companies is as follows:
| Altman Z-Score = 3.25 + 6.56A + 3.26B + 6.72C + 1.05D |
Where:
A = (Current assets — current liabilities) ÷ Total assets
B = Retained earnings ÷ Total assets
C = EBIT ÷ Total assets
D = Equity book value ÷ Total liabilities
The five financial ratios in Z-Score explained
Here are the five financial ratios that together make up the Z-score:
1. Working capital/Total assets (WC/TA)
Working capital refers to the difference between the company’s total assets and its ongoing liabilities. A positive working capital to total assets ratio reflects the company’s ability to meet its short-term obligations. On the other hand, a company with a negative WC/TA ratio means it cannot pay off these obligations.
2. Retained earnings/Total assets (RE/TA)
The RE/TA ratio shows the retained earnings or losses in a company. A low ratio primarily indicates the company’s reliance on borrowed funds and an increasing bankruptcy risk. Conversely, a high RE/TA ratio reflects profitability and reduced dependence on borrowing. This ratio measures reinvested earnings and indicates the company’s leverage and financial stability.
3. Earnings before interest and tax/Total assets (EBIT/TA)
Earnings before interest and tax, better known as EBIT, shows the company’s operational profitability. Simply put, EBIT is the capacity to generate profits from core activities.
The EBIT/TA ratio assesses the company's ability to maintain profitability, sustain operations, and meet debt obligations. It gauges how efficiently the company generates profits from its assets before accounting for interest and tax expenses.
4. Market value of equity/Total liabilities (ME/TL)
Market value is the equity value of a company. To calculate the market value, you need to multiply the number of outstanding shares with the current stock price. The ME/TL ratio indicates how much a company’s market value might drop if it declares bankruptcy before liabilities exceed assets. A high ratio suggests strong investor confidence in the company’s financial health.
5. Sales/Total assets (S/TA)
The sales-to-total assets ratio reflects management's competitiveness and asset efficiency in revenue generation. A high S/TA ratio indicates efficient sales generation with minimal investment, boosting overall profitability. Conversely, a low or declining S/TA ratio signifies increased resource requirements for sales generation, potentially lowering profitability.
Limitations of the Altman Z-Score
The Altman Z-Score model can be useful to assess a company’s financial strength and predict its likelihood of going bankrupt. However, it has a few limitations that you must be aware of before you rely entirely on this score.
1. Heavy reliance on past data
Although the Altman Score is a valuable predictive model, it relies on historical financial data. As businesses undergo change, the model might miss recent financial shifts, which can sometimes lead to inaccurate or outdated assessments.
2. Low accuracy
With the Altman Z-Score, you can predict if a company is likely to go bankrupt — but not when it is likely to happen. The lack of accuracy in this aspect can be vague and confusing for investors.
3. Abnormalities overlooked
Some businesses may be financially sound, but abnormalities like a negative working capital cycle could pull the Altman Z-Score down. However, these abnormalities may not be indicators of insolvency at all.
4. Not suitable for early-stage businesses
The Altman Z-Score model is not well suited for companies that are in the early stages of their business. These entities may be growing rapidly but may not be profitable yet, leading to misleading scores.
Conclusion
To overcome the limitations, ensure that you factor in other indicators as well — like ratio analysis, trend analysis, cash flow analysis and industry comparison. Using these techniques along with the Altman Z-Score can give you a holistic overview of a company’s financial strength and creditworthiness.
