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Altman Z-Score for public companies definition

Description

Altman Z-Score is a mathematic (quantitative balance-sheet method) model used to evaluate the company’s probability of bankruptcy in the next two years. This model was created combining five different financial ratios, calculated using the accounting data of those companies that had already gone bankrupt in the past. This model does not calculate the exact probability of a company’s bankruptcy. It is more of a statistics – based model, developed in 1968, but is still the most widely used one. Data needed to calculate this ratio is collected from the balance sheet, income statement and stock market bulletin, and the cash flow statement.

Altman Z-score calculations are not recommended for financial companies. This bankruptcy calculation model is important for the company’s investors and creditors (also owners), as it provides information on how close the company is to a possible bankruptcy.

Norms and limitations

The value of Z-score, calculated for public companies usually has the following intervals:

Above 2.99 means that the possibility of company’s bankruptcy is very low, so the company is considered safe. This interval is known as the “safe zone”.

A value between 1.8 and 2.99 indicates the possibility of the company going bankrupt within the next two years. This interval is known as the “grey zone”.

If the value is below 1.8 it means that the possibility of company going bankrupt is high, therefore the company is considered unstable and dangerous. This interval is known as the “distress zone”.

In general if the value of Altman Z-Score goes down to 3 or below, it would be smart to consider paying serious attention to the company’s condition.

Formula

Assets (Total assets) - a balance sheet item, representing what a company owns.

Debt (total debt, total liabilities) is calculated by adding together the long term debt with the short term debt. These two measures can be easily located on the balance sheet.

Net sales (revenues, sales) can be described as sales, deducting returns and discount for customers.

Stock price shows the total price of all shares outstanding at the current market price.

Working capital (net working capital, NWC) is calculated by deducting current liabilities (current debts) from current assets.

Retained earnings is a measure that shows a part of net income, which wasn’t paid out to the shareholders as a form of dividends.

Earnings before interest and taxes (EBIT) equal net income, plus interest expense, plus taxes.