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Altmans Z-score

IndianMoney.com Research Team | Updated On Saturday, September 27,2014, 12:21 PM
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Altmans Z-score

 

What It Measures

The z-score is a measure of the financial health of a company. The score uses statistical techniques to predict the likelihood that a company will fail because of bankruptcy within two years.

Why It Is Important

Since the 1980s, auditors have used the z-score to help identify companies with serious cash problems. The measure is also used to help score applicants for loans. Stockbrokers commonly use the z-score to determine if a company is a good investment.

How It Works in Practice

The z-score combines five common business ratios and uses a weighting system devised by Altman to produce a score somewhere between -4 and +8. Each of the components that make up the final z-score is rated independently, and each component has a different weight in the calculation of the overall z-score. The exact emphasis on each factor can vary slightly from one industry to another, using more specific z-score calculators.

All the information needed to calculate a z-score is available in company financial reports. The original formula to calculate a z-score is as follows :

z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + 0.999T5

Where
T1=Working capital/Total assets
T2 = Retained Earnings/Total Assets
T3 = EBIT/Total Assets
T4 = Market value of equity/book value of total liabilities
T5 = Sales/Total Assets

Analysis

A score can be analyzed as follows :
>2.99: the company is considered "safe"
1.8–2.99: there is some risk of financial distress
<1.8: there is serious risk of financial distress

Importance of Z-Score

  • Although the numbers that go into the z-score can be influenced by external events, it is a useful tool to provide a quick analysis of where a company stands compared to competitors, and for tracking the risk of insolvency over time.
  • Studies have shown the z-score is an accurate prediction of company failure rates in between seven and eight out of 10 cases.
  • The formula was originally devised to be use public companies, but amendments have since been made to allow z-scores to be calculated for privately held companies. In this case, the calculation that should be used is as follows :

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