A combination of ratios is sometimes used for a better understanding of a company’s financial status and health. If the DuPont model was expanded for a better understanding of the return on equity, then the Altman Z Score model was developed to understand the company’s health, creditworthiness and the likelihood of its bankruptcy, by considering the effects of assets, profits, and market value. Originally developed in 1968 by professor Edward I. Altman of NYU, the financial model adopted a weighting system combined with a set of five financial ratios to predict a company’s probability of failure.
Original Model ZScore for Public Manufacturing Companies:
ZScore = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5
Where,
X1 = Working Capital ÷ Total Assets (Measures the net liquid assets relative to the total assets)
X2 = Retained Earnings ÷ Total Assets (Measures the financial leverage level of a company)
X3 = Earnings before Interest & Taxes ÷ Total Assets (Measures productivity of a company’s total assets)
X4 = Market Value of Equity ÷ Book Value of Total Liabilities (Measures what portion of a company’s assets can decline in value before the liabilities exceed the assets)
X5 = Sales ÷ Total Assets (Measures revenuegenerating ability of a company’s assets)
When analysing the ZScore of a company, the lower the value, the higher the chances for the company to head towards bankruptcy. The rules of interpretation of Zscore are as follows:

Below 1.8 indicates a firm is headed for bankruptcy;

Above 3.0 indicates a firm is unlikely to enter bankruptcy; and

Between 1.8 and 3.0 cannot be predicted and is a grey area.
Additional Models
Dr. Altman created three different Z Score Models. While the original model developed in 1968 was for large companies, in 1983, he expanded by creating two more models  Model “A” ZScore was developed for use with private manufacturing companies. Model “B” was developed for nonpublic traded general firms and the service sector.
Model ‘A’  ZScore for Private Manufacturing Companies
This model replaces the market value of equity with the book value in X4, compared to the original model.
ZScore = 0.717X1 + 0.847X2 + 3.107X3 +0.420X4 +0.998X5
Where,

X1 = Working Capital ÷ Total Assets

X2 = Retained Earnings ÷ Total Assets

X3 = Earnings before Interest & Taxes ÷ Total Assets

X4 = Book Value of Equity ÷ Book Value of Total Liabilities

X5 = Sales ÷ Total Assets
The rules of interpretation of Zscore are as follows:

Below 1.23 indicates a firm is headed for bankruptcy;

Above 2.9 indicates a firm is unlikely to enter bankruptcy; and

Between 1.23 and 2.9 cannot be predicted and is a grey area.
Model ‘B’ Z  Score for Private General Companies:
This model analysed the characteristics and accuracy of a model without X5 – sales/total assets.
ZScore = 6.56X1 + 3.26X2 +6.72X3 +1.05X4
Where,

X1 = Working Capital ÷ Total Assets

X2 = Retained Earnings ÷ Total Assets

X3 = Earnings before Interest & Taxes ÷ Total Assets

X4 = Book Value of Equity ÷ Book Value of Total Liabilities
The rules of interpretation of Zscore are as follows:

Below 1.10 indicates a firm is headed for bankruptcy;

Above 2.6 indicates a firm is unlikely to enter bankruptcy; and

Between 1.10 and 2.6 cannot be predicted and is a grey area.
PurposeModel
The purpose of the Z Score Model is to measure a company’s financial health and to predict the probability that a company will collapse and go bankrupt within 2 years. It is proven to be very accurate to forecast bankruptcy with studies showing that the model has 75% and 95% reliability of predicting bankruptcy with 1 year and 2 years respectively, across companies.
All the financial ratios highlighted in this section can help the investors in making the necessary computations to understand the health and performance of any company and also, help in peer comparison to provide sufficient information on valuations, thereby resulting in any investment. However, all these computations are based on past information or the trailing twelvemonth information, which helps in understanding but not providing any outlook into the future.
For that purpose, a fundamental and technical analysis has to be done, to identify the prospects of investing. Before commencing the section on fundamental analysis, a collation of all these ratios is provided as a ready reckoner. This will be handy during the fundamental analysis and hence, is made available as a quick glance sheet.
Important Financial Ratios at a Glance

Gross Profit Margin = Gross Profit ÷ Net Sales

Net Profit Margin = Net Profit ÷ Net Sales

Return of Assets = Net Profit ÷ Total Average Assets

Return on Net Assets = Net Profit ÷ (Fixed Assets + Net Working Capital)

Return on Capital Employed = EBIT ÷ (Total Assets – Current Liabilities)

Return on Invested Capital = (Net Profit – Dividends) ÷ Total Capital Employed

Return on Equity = Net Profit ÷ Average Shareholder’s Equity

DuPont formula (RoE) = Net Profit Margin * Asset Turnover Ratio * Equity Multiplier

Current Ratio = Current Assets ÷ Current Liabilities

Quick Ratio = Quick Assets ÷ Current Liabilities

Cash Ratio = (Cash + Marketable Securities) ÷ Current Liabilities

Inventory Turnover Ratio = Cost of Goods Sold ÷ Average Inventory for the period

Days inventory Outstanding = 365 Days ÷ Inventory Turnover Ratio

Accounts Receivable Turnover Ratio = Net Credit Sales ÷ Average Accounts Receivable

Days Sales Outstanding = 365 Days ÷ Accounts Receivable Turnover Ratio

Accounts Payable Turnover Ratio = Net Credit Purchases ÷ Average Accounts Payable

Days Payable Outstanding = 365 Days ÷ Accounts Payable Turnover Ratio

Operating Cycle (Days) = Days Inventory Outstanding + Days Sales Outstanding

Cash Conversion Cycle (Days) = Operating Cycle – Days Payable Outstanding

Working Capital Turnover Ratio = Net sales ÷ Average Working Capital

Fixed Asset Turnover Ratio = Net Sales ÷ Total Average Fixed Assets

Total Asset Turnover Ratio = Net Sales ÷ Total Average Assets

Debt Ratio = Total Debt ÷ Total Assets

Equity Ratio = Total Shareholder’s Equity ÷ Total Assets

Equity Multiplier = Total Assets ÷ Shareholder's Equity

Debt to Equity Ratio = Total Debt ÷ Total Shareholder’s Equity

Long term Debt to Capitalization = Long Term Debt ÷ Total Capital

Interest Coverage Ratio = Earnings before Interest and Taxes ÷ Interest Costs

Degree of Operating Leverage = Change in EBIT (%) ÷ Change in Sales (%)

Degree of Financial Leverage = Change in EPS (%) ÷ Change in EBIT (%)

Degree of Combined Leverage = Change in EPS (%) ÷ Change in Sales (%)

Operating Cash Flow = Operating Income + Depreciation  Taxes ± Change in Working Capital

Free Cash Flow = Operating Cash Flow  Capital Expenditure

Operating cash flow to Sales Ratio = Cash flow from Operating Activities ÷ Net Sales

Free Cash Flow to Operating Cash Flow Ratio = Free Cash Flows ÷ Operating Cash Flows

Cash Flow Coverage Ratio = Operating Cash Flows ÷ Total Debt

Cash Flow per Share = Operating Cash Flow ÷ Total Shares Outstanding

Cash Flow Liquidity ratio = (Cash & Cash Equivalents + Marketable Securities + Operating Cash Flow) ÷ Total Liabilities

Dividend Payout Ratio = Total Dividends ÷ Net Profit

Cash Flow Return on Investment = Operating Cash Flow ÷ Capital Employed

Cash Return on Gross Investment = Operating After Tax Cash Flow ÷ Gross Investment

Price to Earnings ratio = Current market price of the share ÷ Earnings per share

Price to Sales ratio = Current Market Price of the Share ÷ Net Sales per Share

Price to Book Value ratio = Current Market Price per Share ÷ Book Value per Share

Price to Cash Flow ratio = Current Market Price Per Share ÷ Operating Cash Flow per Share

Price to Earnings to Growth ratio = Price / Earnings ÷ Annual EPS Growth

Dividend Yield (%) = Total Dividend per Share ÷ Current Market Price of the share

Altman ZScore = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5,

X1 = Working Capital ÷ Total Assets;

X2 = Retained Earnings ÷ Total Assets;

X3 = Earnings before Interest & Taxes ÷ Total Assets;

X4 = Market Value of Equity ÷ Book Value of Total Liabilities;

X5 = Sales ÷ Total Assets


Enterprise Value = Market Capitalization + Market Value of Debt – Cash and Equivalents
Points of Note

Any ratio should not be considered on a standalone basis, but should be used in conjunction with other ratios for an appropriate understanding.

Parameters related to balance sheet should be considered on an ‘average’ basis – (beginning + ending)/2, to account for the various changes occurring during the course of yearly operations which can affect working capital, assets, liabilities etc.

Industry averages like P.E., RoE’s etc. have to be used for comparing companies in a same sector and not across sectors.

Also, factoring in all the tailwinds and headwinds might not be possible at times and hence, valuation computations might differ from time to time.
With this background, the next sections will work towards detailing the macroeconomic and microeconomic concepts and continuing on, to address the process of fundamental and technical analyses of companies.
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