Altman Z-Score - Explained
What is the Altman Z - Score?
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Table of ContentsWhat is the Altman Z-Score?How is the Altman Z-Score Used?The formula Altman Z-scoreHow to use the Altman z-score to predict bankruptciesAcademic Research on the Altman Z-Score
What is the Altman Z-Score?
The Altman Z-score (or simply, "Z-Score") is a statistical measurement of one variables relationship to the mean (average) of a group of values. More specifcally, the Z-score states the number of standard deviations a variable lies from the mean of the group of values. A zero Z-score indicates that the mean of the group and the value being tested is identical. A one or negative one Z-score indicates that the value is one standard deviation from the mean. A positive one indicates that it is one standard deviation above, while a negative one indicaes that it is one standard deviation below the mean. Z-scores are measures of an observation's variability and can be put to use by traders in determining market volatility. The Z-score is more commonly known as the Altman Z-score. The Altman Z-Score is the formula, consisting of five fundamental ratios, used to determine the financial condition of the company and probability for bankruptcy. The Altman Z-Score formula helps the investors to evaluate the businesss financial strength. This Formula also helps predicting the businesss bankruptcy
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How is the Altman Z-Score Used?
The Altman Z-Score determines the company's strength by calculating its financial risk. It highlights the bankruptcy probabilities using various financial indices. The Altman Z-Score was introduced by Edward Altman, a professor at the University of New York, in 1960. The Altman Z-Score is a valuable tool to evaluate the companys operations. This fundamental tool measures the companys viability in the long term, which is helpful for the capital investors to determine the companys bankruptcy. The poor assessment of the companys financial viability may cause investor huge lauses. The Altman Z-Score models uses multivariate statistical technique called discriminant analysis. It is used to assess the credit studies or project the movement of the treasury of a potential client.
The formula Altman Z-score
The Altman Z-score formula calculation is as follows: Altman Z-score = 1.2 * T 1 + 1.4 * T 2 + 3.3 * T 3 + 0.6 * T 4 + 1.0 * T 5 Where: T 1 : (Working Capital / Total Assets) T 2 : (Undistributed profits / Total Assets) T 3 : (EBITDA / Total Assets) T 4 : (Stock Market Capitalization / Total Debt) T 5 : (Net Sales / Total Assets)
How to use the Altman z-score to predict bankruptcies
The result of the Altman Z-score formula determines if the company is in the safe zone, gray zone or in danger zone. Z-score more than 2.99 means Safe area. Z-score between 1.81 and 2.99 means a gray area, specifying that the company may go bankrupt in the following two years. Z-score less than 1.81 means the danger zone; i.e. Imminent bankruptcy. The accuracy of the Altman Z-score in the prediction of bankruptcies The Altman Z-score formula is 72% accurate two years in advance concerning the bankruptcy, with a false negative rate of 6%. In its trial era of 31 years, the accurate rate was in between 80% and 90%, one year in advance concerning the bankruptcy, with a false negative rate in between 15% and 20%. Hence, it can be said that the Altman Z-score formula predictions are considerably accurate. However, it is not an absolute formula, thus, must be used in parallel with a qualitative analysis of the business for more accurate predictions.