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Altman Z Score Financial Models

It's a combination of ratios which helps to understand a company's health, creditworthiness and the likelihood of it's bankruptcy.

Gopal Kavalireddi
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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 Z-Score for Public Manufacturing Companies:

Z-Score = 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 revenue-generating ability of a company’s assets)

When analysing the Z-Score of a company, the lower the value, the higher the chances for the company to head towards bankruptcy. The rules of interpretation of Z-score 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” Z-Score was developed for use with private manufacturing companies. Model “B” was developed for non-public traded general firms and the service sector. 

 

Model ‘A’ - Z-Score for Private Manufacturing Companies

This model replaces the market value of equity with the book value in X4, compared to the original model.

Z-Score = 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 Z-score 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.

Z-Score = 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 Z-score 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 twelve-month 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

  1. Gross Profit Margin = Gross Profit ÷ Net Sales

  2. Net Profit Margin = Net Profit ÷ Net Sales

  3. Return of Assets = Net Profit ÷ Total Average Assets

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

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

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

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

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

  9. Current Ratio = Current Assets ÷ Current Liabilities

  10. Quick Ratio = Quick Assets ÷ Current Liabilities

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

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

  13. Days inventory Outstanding = 365 Days ÷ Inventory Turnover Ratio

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

  15. Days Sales Outstanding = 365 Days ÷ Accounts Receivable Turnover Ratio

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

  17. Days Payable Outstanding = 365 Days ÷ Accounts Payable Turnover Ratio

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

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

  20. Working Capital Turnover Ratio = Net sales ÷ Average Working Capital

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

  22. Total Asset Turnover Ratio = Net Sales ÷ Total Average Assets

  23. Debt Ratio = Total Debt ÷ Total Assets

  24. Equity Ratio = Total Shareholder’s Equity ÷ Total Assets

  25. Equity Multiplier = Total Assets ÷ Shareholder's Equity

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

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

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

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

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

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

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

  33. Free Cash Flow = Operating Cash Flow - Capital Expenditure

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

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

  36. Cash Flow Coverage Ratio = Operating Cash Flows ÷ Total Debt

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

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

  39. Dividend Payout Ratio = Total Dividends ÷ Net Profit

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

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

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

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

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

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

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

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

  48. Altman Z-Score = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5,

    1. X1 = Working Capital ÷ Total Assets;

    2. X2 = Retained Earnings ÷ Total Assets;

    3. X3 = Earnings before Interest & Taxes ÷ Total Assets;

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

    5. X5 = Sales ÷ Total Assets

  49. Enterprise Value = Market Capitalization + Market Value of Debt – Cash and Equivalents

 

Points of Note

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

  2. 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.

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

  4. 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.

 

Next Chapter

Introduction to Economic Factors

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