A Comprehensive Review of the Altman Z-Score Model

Altman Z-Score is a valuable tool for initial risk assessment, it should be used in conjunction with other qualitative and quantitative analyses to obtain a comprehensive view of a company’s financial health.

The Altman Z Score model separates itself by offering a comprehensive analysis of a company's financial well-being beyond traditional ratios. By categorizing enterprises into safe, gray, and distress zones, the Altman Z-Score provides valuable insights for financial decision-makers.

Companies are assumed to have perpetual life, but in reality companies have become bankrupt and others are financially distressed.

Bankruptcy is a situation where a company finds itself in a situation it cannot operate as a going concern.

Financial health is a primary financial health is a primary concern in the ever-evolving landscape of global business. Credit Manager, creditors, and financial analysts are constantly looking for reliable techniques to assess the health and resilience of businesses across a wide range of industries. One such essential instrument that has endured the test of time is the Altman Z Score model, suggested by Altman (1968).

The Altman Z score is the most extensively used measure for assessing financial distress. The model examines a company's financial stability by examining its financial statements and ratios. The model considers parameters such as profitability, leverage, liquidity, solvency, and activity. The model is comprised of five financial ratios, each indicating a specific aspect of a firm's financial health.

The Altman Z-Score, which evolves over time, provides a comprehensive view of a company's financial health, providing insights into its likelihood of bankruptcy and overall stability.

The Altman Z-Score serves as a valuable tool for assessing and predicting financial health across various economic landscapes, including public enterprises, private enterprises, and emerging economies. Public enterprises, which often operate under distinct regulatory frameworks, derive benefit from the Altman Z-Score as it provides a comprehensive evaluation of their financial stability.

Emerging markets, characterized by rapid growth and distinctive financial structures, require a specialized perspective for risk assessment. Altman identified this need and adjusted the model, introducing modifications to accommodate the peculiarities of emerging economies.

The Five Financial Ratios in Z-Score Explained

The following are the key financial ratios that make up the Z-score model:

1. Working Capital/Total Assets        

Net working capital is ascertained by deducting current liabilities from current assets. This ratio assumes a pivotal role in evaluating a firm's capacity to fulfill its immediate financial obligations. In situations where a firm regularly encounters operational losses, the proportion of current assets to total assets tends to decrease.

Net working capital (NWC), is the difference between a company’s current assets—like cash, accounts receivable/customers’ unpaid bills, and inventories of raw materials and finished goods—and its current liabilities, such as accounts payable and debts. It's a commonly used measurement to gauge the short-term financial health and efficiency of an organization.

A positive working capital means that a company can meet its short-term financial obligations and still make funds available to invest and grow.

In contrast, negative working capital means that a company will struggle to meet its short-term financial obligations because there are inadequate current assets.

A higher ratio indicates an increased capacity for the firm to effectively manage short-term financial difficulties.

Please Note High working capital isn’t always a good thing. It might indicate that the business has too much inventory, is not investing its excess cash, or is not taking advantage of low-cost debt opportunities.

2. Retained Earnings/Total Assets        

The retained earnings/total assets ratio provides insights into the extent to which a firm has utilized its retained earnings to strengthen its asset base rather than relying heavily on debt financing. A higher value of this ratio indicates a strong financial standing, characterized by a reduced dependency on external debt. Conversely, a lower ratio of retained earnings may imply diminished longevity for the firm.

If a company reports low retained earnings to the total asset’s ratio, it means that it is financing its expenditure using borrowed funds rather than funds from its retained earnings. It increases the probability of a company going bankrupt.

A high retained earnings to total assets ratio shows that a company uses its retained earnings to fund capital expenditure. It shows that the company achieved profitability over the years, and it does not need to rely on borrowings.

• Retained earnings are the amount of net income left over for the business after it has paid out dividends to its shareholders.
• The decision to retain the earnings or distribute them among shareholders is usually left to company management.
• A growth-focused company may not pay dividends at all?or pay very small amounts because it may prefer to use retained earnings to finance expansion activities.
• Companies may choose to use their retained earnings for increasing production capacity, hiring more sales representatives, launching a new product, or share buybacks, among others.
• Retained earnings are an important variable for assessing a company’s financial health because they show the net income that a company has saved over time and therefore can reinvest in the business or distribute to shareholders.

3. Earnings Before Interest and Tax/Total Assets        

EBIT, a measure of a company’s profitability, refers to the ability of a company to generate profits solely from its operations. The EBIT/Total Assets ratio demonstrates a company’s ability to generate enough revenues to stay profitable and fund ongoing operations and make debt payments.

Essentially, it assesses how effectively a firm's assets are utilized to generate operating income.

Earnings before interest and taxes (EBIT) is the amount of profit remaining from total revenue after deducting all expenses except interest and income taxes. It represents the company's ability to generate profit from operations.

EBIT is calculated as under:

EBIT = Net Income + Interest + Taxes

Or

EBIT = EBITDA – Depreciation and Amortization Expense

A higher ratio indicates that the firm is generating a significant operating income per unit of total assets, exhibiting operational effectiveness. Examining this ratio over time provides valuable insights into a company's ability to effectively utilize its asset base for profitability, making it a key metric in evaluating the financial health and efficiency of the company.

?4. Market Value of Equity/Total Liabilities        

The market value, also known as?market capitalization, is the value of a company’s equity. It is obtained by multiplying the number of outstanding shares by the current price of stocks.

This ratio introduces a market value dimension to the model, thereby providing insights into the potential for financial distress. Moreover, it serves as a pivotal indicator of a firm's long-term financial stability. A higher ratio not only signifies investor confidence but also signifies a reduced risk of bankruptcy.

The market value of the equity/total liabilities ratio shows the degree to which a company’s market value declines when it declares bankruptcy before the value of liabilities exceeds the value of assets on the balance sheet.

In Case of non listed company market value is replaced by Book Value & Book value of equity is normally recognized in the statement of financial position, and it includes: share capital, general reserves, retained earnings and revaluation reserves it can also be measured as the difference between the total assets and the total liabilities.

A high market value of equity to the total liability ratio can be interpreted to mean high investor confidence in the company’s financial strength.

Generally, there is a negative relationship between profitability and debt ratio. A profitable firm will accommodate situations of economic recession; creditors prefer to lend more to profitable firms. According to the tradeoff theory, firms with a high total asset in relation to debt are associated with lower costs of financial distress, since tangible assets are less likely to be subjected to a big loss of value in case of bankruptcy.

5. Sales/Total Assets        

This ratio provides valuable insights into the ability of management to effectively navigate competitive conditions. Specifically, it demonstrates how proficiently a firm utilizes its assets to generate revenue, thereby offering valuable information regarding operational efficiency. This ratio serves as an indicator of a company's effective use of assets to generate sales. Net Sales is the gross sales minus returns, allowances, and discounts.

The sales to total assets ratio shows how efficiently the management uses assets to generate revenues vis-à-vis the competition. A high sale to total assets ratio is translated to mean that the management requires a small investment to generate sales, which increases the overall profitability of the company.

In contrast, a low or falling sales to total assets ratio means that the management will need to use more resources to generate enough sales, which will reduce the company’s profitability.

The sales-to-total-assets ratio remains a crucial measure of a company's operational excellence and its ability to convert assets into revenue efficiently.

Altman Z score model for public enterprises

The Z-score model was introduced as a way of predicting the probability that a company will collapse in the next two years. The model proved to be an accurate method for predicting bankruptcy on several occasions. According to studies, the model showed an accuracy of 72% in predicting bankruptcy two years before it occurred, and it returned to a false positive of 6%. The false-positive level was lower compared to the 15% to 20% false-positive returned when the model was used to predict bankruptcy one year before it occurred.

When creating the Z-score model, Altman used a weighting system alongside other ratios that predicted the chances of a company going bankrupt. In total, Altman created three different Z-scores for different types of businesses.

The original model was released in 1968, and it was specifically designed for public manufacturing companies with assets in excess of $1 million. The original model excluded private companies and non-manufacturing companies with assets less than $1 million.

ζ = 1.2 A + 1.4 B + 3.3 C + 0.6 D + 1.0 E        

Where:

• Zeta?(ζ) is the Altman’s Z-score
• A?is the Working Capital/Total Assets ratio
• B?is the Retained Earnings/Total Assets ratio
• C?is the Earnings Before Interest and Tax/Total Assets ratio
• D?is the Market Value of Equity/Total Liabilities ratio
• E?is the Total Sales/Total Assets ratio

Usually, the lower the Z-score, the higher the odds that a company is heading for bankruptcy. A Z-score that is lower than 1.8 means that the company is in financial distress and with a high probability of going bankrupt. On the other hand, a score of 3 and above means that the company is in a safe zone and is unlikely to file for bankruptcy. A score of between 1.8 and 3 means that the company is in a grey area and with a moderate chance of filing for bankruptcy.

Credit Manager use Altman’s Z-score to make a decision on whether to lend a company’s depending on the assessed financial strength. If a company shows a Z-score closer to 3, the Credit Manager may consider the proposal since there is a minimal risk of the business going bankrupt in the next two years.

If a company shows a Z-score closer to 1.8, the Credit manager may consider to avoid taking exposure in the company to avoid future reporting as NPA / distress assets since the score implies a high probability of going bankrupt.

Altman Z score model for Private enterprises

The Altman Z-Score model was originally developed for publicly traded manufacturing companies. However, since private enterprises do not have a market valuation for their equity, Altman modified the formula to make it applicable to privately held manufacturing firms.

Altman proposed a substantial revision. This involved undertaking a comprehensive estimation of the model by substituting the market value with the book value of equity , while also making adjustments to weights and cut-off scores. Through this modification, Altman formulated the revised Z-Score Model, which aimed to ensure a wider scope of applicability. The modified model is expressed in the following manner:

ζ =0.717 A + 0.847 B + 3.107 C + 0.420 D + 0.998 E        

Where:

• D?is the Book Value of Equity/Total Liabilities ratio

For Non-Manufacturing and Service Companies

Non-manufacturing firms typically have different capital structures and asset bases. A modified version of the Z-Score excludes E (Sales/Total Assets):

ζ = 6.56 A + 3.26 B + 6.72 C + 1.05 D        

Example for Manufacturing (Private Limited Company)

Template for calculation of Altman Z Score

Altman Z score model for Emerging economies

Altman acknowledged the distinct requirements of developing economies and took proactive steps to refine the Z-Score model by incorporating a constant term into its equation. However, it became evident that the current version of the model did not fully address the specific requirements of emerging markets. Considering this realization, Altman made further adjustments to the model equation by incorporating an additional constant of 3.25.

This strategic modification aimed to enhance the model's effectiveness within the context of emerging economies. Altman maintained the previously established set of cutoff limits and weights, which served as crucial benchmarks for categorizing firms into distinct solvency zones. The emerging market model is shown below:

ζ = 3.25 + 6.56 ?A + 3.26 B + 6.72 C + 1.05 D        

This formula does NOT include Sales/Total Assets (E) because asset turnover varies significantly across emerging markets.

The Altman Z-score model has been extensively studied for the past four decades and has proven to be a highly effective tool for measuring financial distress. Its application extends to various sectors, such as the service industry, manufacturing, publicly traded companies, and financial institutions, where it has demonstrated immense value in predicting bankruptcy scenarios.

?It can be confidently asserted that Altman's Z-score model remains relevant in the contemporary economy, offering the ability to foresee distress and bankruptcy. As a result, the Altman Z-score model can be a useful tool for Credit Manager, regulators, and other stakeholders who are interested in assessing a company's financial situation.

Limitations of Altman Z – Score:-

While the Altman Z-Score is a useful tool for assessing bankruptcy risk, it does have several limitations:

1. Industry Specificity: Designed for Manufacturing: The original model was developed using data from publicly traded manufacturing firms. Its predictive power can be less reliable for non-manufacturing industries, such as service companies or tech startups. Modified Versions Needed: Although adaptations exist for private and non-manufacturing companies, they may not always capture the nuances of these sectors accurately.
2. Historical Data Dependence: Static Snapshot: The score is calculated using historical financial data. It may not reflect current or future market conditions or sudden changes in the company’s operating environment. Lag in Reporting: Financial statements are typically published quarterly or annually, which means the data used might already be outdated.
3. Accounting Practices Variability: Subjectivity: Differences in accounting practices and standards between companies (or even within industries) can lead to inconsistencies in the financial ratios used in the Z-score calculation. Manipulation Risk: Companies might use aggressive accounting techniques to improve their financial appearance, which can skew the ratios.
4. Limited External Factors: Macro-Economic and Industry Trends: The model does not incorporate broader economic conditions, regulatory changes, or industry-specific trends that can impact a company’s financial health. Management and Market Dynamics: Qualitative factors such as management quality, competitive position, and market dynamics are not considered in the score.
5. Threshold Rigidity: Gray Areas: The thresholds (e.g., Z > 3.0 indicating low risk, Z < 1.8 indicating high risk) may not universally apply to every company, and firms operating in different environments might not fit neatly into these categories.
6. Applicability to Modern Business Models: Changing Business Structures: The financial landscape has evolved since the model was developed, and modern business models (e.g., tech companies with significant intangible assets) might not be adequately evaluated by a model built on traditional manufacturing metrics.

Altman Z-Score is a valuable tool for initial risk assessment, it should be used in conjunction with other qualitative and quantitative analyses to obtain a comprehensive view of a company’s financial health.

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