Reviewed by Aug 27, 2020| Updated on
What is Altman Z-Score?
Altman Z-Score is the measure of creditworthiness of a company, irrespective of it being privately or publicly held. This mathematical model investigates scientifically to predict the possibility of a company claiming bankruptcy. Initially, there was a single Altman Z-score model; with time, several different models came into existence.
Stakeholders interested in a company's creditworthiness use the Altman Z-score to determine its performance. Based on this score, they choose the company they would like to invest in or lend money. Usually, banks check this score to determine the risk associated with issuing business loans. Private investors use this score because the data required to compute the score is easy to obtain.
Variables Associated with Altman Z-Score
- Market value: The total of all outstanding shares of a company is called the market value. - Book value: Long-term and short-term debts constitute the book value of a company, and it is found in the balance sheet. The reserves found on the credit side of the balance sheet is not part of the company's book value. - Turnover: The total sales seen by the company in a year is called turnover. It should be recorded in the same book year as the used profit before tax and interest (EBIT). - Total assets: All the assets found on the balance sheets are together known as total assets, including the cash and properties that needed longer-term investments. - Total retained earnings: The sum of all profits earned in the past that was used for reinvesting in the company is known as total retained earnings. This parameter does not take into account taxes and dividends. - Working capital: The money used to fund the company's activities is known as working capital. The primary characteristic of working capital is that the funds must be available at short notice. It is calculated by deducting the current short-term debts from cash and cash equivalents. * - Profit before tax and interest:* This refers to the profit earned by a company in a certain book year before deducting tax and interest payments.
Formula to Calculate Altman Z-Score
Altman Z-Score = 1.2xWorking capital/total assets + 1.4xTotal retained earnings/total assets + 3.3xProfit before interest and tax/total assets + 0.6xMarket value/book value + 1.0xSales/total assets
- The company is predicted to go bankrupt if the score is below 1.81
- A score between 1.81 and 2.99 belongs to a grey area. If the score below 2.675, there are 95% chances that the company will go bankrupt.
- A score of 3.0 or more indicates a low risk of bankruptcy.