You are currently viewing Altman’s Z Score: Corporate Bankruptcy Formula | Overview & Analysis

Altman’s Z Score: Corporate Bankruptcy Formula | Overview & Analysis

  1. This applies to however small or large your business is** No conditions applyA fundamental part of Business Health analysis is to diagnose the signs of Business Distress and suggest the corrective measures and actions that would aid the business to handle any shortcomings and make sure that any business distress will be cured.Corporate failure can be identified through two models:

    Qualitative (Non-Financial Information) and;

    Quantitative (Financial Information).

    This article identifies Business Distress (a preventive test) purely based on the Quantitative Model, mainly encompassing a logical combination of various ratios that act as preventive medicine and create alerts.

    X-ray and Test

    Health analysis can be done through various methods, one of which is the X-ray method.

    We will now chalk out a business X-ray.

    Assumptions:

    1. This is the first year of incorporation of the Company
    2. Interest on Secured loans is 14% using the straight-line method, and holidays are ignored
    3. Provision for Advance Tax is not applicable.

    Identification: Based on the above Financial Statements:

    1. The Entity has achieved a turnover of more than 2 lakhs per month (in its first year) – Good.
    2. Profitability is above 22% – Excellent but based on the X-ray, the Company looks good. However, we cannot analyze and decipher the exact health, so we need to perform more substantive testing, which is called Z Test or Z score.

    Z Score: Calculating a Z score: The Z score is generated by combining ratios, which is an attempt to provide a comprehensive picture of an entity’s financial status under consideration.

    To be more specific, it is nothing but a calculation of five ratios, which are then multiplied by a pre-determined weighting factor and added together to produce the Z score.

    History: NYU Stern Finance Professor Edward Altman, developed the Altman Z-score formula in 1967, and it was published in 1968. In 2012, he released an updated version called the Altman Z-score plus that can be used to evaluate public and private companies, manufacturing and non-manufacturing companies, and the U.S. and non-U.S. companies. The Altman Z-score Plus can be used to evaluate corporate credit risk. The formula is as follows:

    Z score = (1.2 X1) + (1.4 X2) + (3.3 X3) + (0.6 X4) + (1.0 X5)

    Where: X1 = working capital/total assets, X2 = retained earnings/total assets, X3 = earnings before interest and tax/total assets, X4 = market value of equity or capital investment/total liabilities, X5 = sales/total assets. These five ratios are the combination of liquidity, profitability, leverage, solvency, and activity ratio with a predefined weight factor.

    The score indicates the likelihood of failure:

    The Pass score for the Z test is 3;

    The Fail score is below 1.81; The Grey Area is a score between 1.81 to 2.99. If we calculate the Z score of the above entity:

    Z score is = 1.05, which signifies an Alert Signal. It is like the Amber light in a traffic signal.

    To sum up: 

    Less than 1.81: Companies with a Z score below 1.81 are in danger and possibly heading towards bankruptcy.

    Between 1.81 and 2.99: Companies with scores between 1.81 and 2.99 need further investigation.

    3 or above: Companies with a score of 3 or above are financially sound. The Z Test enables further investigation into business distress. If we can improve our numbers, we can work towards making our business healthy.

    Limitations:

    Only Quantitative information is considered, and parameters like competition, market condition, type of industry are completely discounted. Z score work on Historical data i.e., it is a postmortem and not projected data. Factors such as management style, approach & strategy are completely ignored. Further analysis is required to fully understand the situation, e.g., cash flow projections, detailed cost information, environmental review. Scores are only good predictors in the short term. Figures are open to manipulation. The Z score model only gives guidance below the danger level of 1.81.

    Further investigation is needed for those organizations with scores between 1.81 and 2.99.

    To summarize and conclude, Organizations should perform the Z Test regularly. This will provide an adequate alert and help the business function without any distress.

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