## Altman Z-Score

The Altman Z-score is a financial metric developed by Dr. Edward I. Altman in 1968. It is a credit-strength test that gauges a company’s likelihood of bankruptcy by analyzing its financial health. The Altman Z-score combines five financial ratios, each assigned a different weight, to produce a single score. The score helps to predict the probability of a company going bankrupt within a two-year period.

The five financial ratios used in the Altman Z-score calculation are:

- Working Capital / Total Assets
- Retained Earnings / Total Assets
- Earnings Before Interest and Taxes (EBIT) / Total Assets
- Market Value of Equity / Total Liabilities
- Sales / Total Assets

These ratios are then multiplied by their respective weights and summed to calculate the Altman Z-score:

Z = 1.2(A) + 1.4(B) + 3.3(C) + 0.6(D) + 1.0(E)

Where:

A = Working Capital / Total Assets

B = Retained Earnings / Total Assets

C = Earnings Before Interest and Taxes (EBIT) / Total Assets

D = Market Value of Equity / Total Liabilities

E = Sales / Total Assets

The resulting Z-score can be interpreted as follows:

- Z-score > 2.99: The company is considered to be in a “safe zone,” with a low probability of bankruptcy.
- 1.81 < Z-score < 2.99: The company is in a “grey zone,” with some risk of bankruptcy, but not critical.
- Z-score < 1.81: The company is in a “distress zone,” with a high probability of bankruptcy.

It’s essential to note that the Altman Z-score was initially developed to assess publicly traded manufacturing companies. Therefore, the model’s accuracy might not be as reliable when applied to other types of companies or industries.

## Example of the Altman Z-Score

Let’s consider a hypothetical company, and we’ll calculate its Altman Z-score using the given financial information:

Working Capital: $150,000 Total Assets: $1,200,000 Retained Earnings: $350,000 Earnings Before Interest and Taxes (EBIT): $270,000 Market Value of Equity: $900,000 Total Liabilities: $750,000 Sales: $1,400,000

Now, we’ll calculate the five financial ratios:

A = Working Capital / Total Assets = $150,000 / $1,200,000 = 0.125

B = Retained Earnings / Total Assets = $350,000 / $1,200,000 = 0.2917

C = EBIT / Total Assets = $270,000 / $1,200,000 = 0.225

D = Market Value of Equity / Total Liabilities = $900,000 / $750,000 = 1.2

E = Sales / Total Assets = $1,400,000 / $1,200,000 = 1.1667

Now we’ll apply the weights to each ratio and sum them to calculate the Altman Z-score:

Z = 1.2(A) + 1.4(B) + 3.3(C) + 0.6(D) + 1.0(E)

Z = 1.2(0.125) + 1.4(0.2917) + 3.3(0.225) + 0.6(1.2) + 1.0(1.1667)

Z ≈ 0.15 + 0.408 + 0.7425 + 0.72 + 1.1667

Z ≈ 3.1872

Based on this Altman Z-score of 3.1872, the hypothetical company is in the “safe zone,” indicating a low probability of bankruptcy. Keep in mind that this example is for illustrative purposes, and the Altman Z-score should be used with caution when assessing companies in different industries or with unique financial structures.