Following the deep recession we have endured and the market instability we are currently experiencing, it is perhaps an interesting time to revisit and review the Altman Z-score.
This measure was devised by Professor Edward Altman in the early 1960s as a way of screening publicly listed companies for bankruptcy risk. Although not full-proof, a success rate of circa 70% does suggest that this is a useful measure along with other research.
Altman suggested a set of five financial ratios (using Multiple Discriminant Analysis) that uses a statistical technique to score a company and thereby predict the company’s probability of failure.
Eight variables are used from the P&L statement and the Balance Sheet to produce five key ratios. These key ratios are then weighted to give the overall single number Z-score.
The five key ratios are: -
1) EBIT/Total Assets
2) Net Sales/Total Assets
3) Market Value of Equity/Total Liabilities
4) Working Capital/Total Assets
5) Retained Earnings/Total Assets
The weighting, in order of the above, are x 3.3, x 0.999, x 0.6, x 1.2 & x 1.4 respectively.
The Z-score = 1+2+3+4+5
A high Z-score of 3 or above indicates a low risk of financial failure and that the company is safe based upon these specific accounts.
A Z-score of 2.7 to 2.99 indicates “On Alert” – this is an area where an investor should exercise caution.
A Z-score of 1.8 to 2.7 indicates a good chance of the Company going bankrupt within 2 years of operations from the Balance Sheet date of the financial figures used.
A Z-score below 1.8 suggests that the possibility of financial collapse is very high.
As an investor then, you a looking for a high Z-score combined with a low p/e and a high yield. As with any measure, when used in isolation you may get skewed results; the power comes in combining the measure with other metrics to provide the most detailed position from the data available.