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The Altman Z-Score Formula Cheat Sheet by

The Altman Z-Score Formula
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Introd­uction - What is a 'Z-Score'

A Z-score is a numerical measur­ement of a value's relati­onship to the mean in a group of values. If a Z-score is 0, it represents the score as identical to the mean score.

Z-scores may also be positive or negative, with a positive value indicating the score is above the mean and a negative score indicating it is below the mean. Positive and negative scores also reveal the number of standard deviations that the score is either above or below the mean.

BREAKING DOWN 'Z-Score'

Z-scores reveal to statis­ticians and traders whether a score is typical for a specified data set or if it is atypical. In addition to this, Z-scores also make it possible for analysts to adapt scores from various data sets to make scores that can be compared to one another accura­tely. Usability testing is one example of a real-life applic­ation of Z-scores.

The Z-score is more commonly known as the Altman Z-score. Edward Altman, a professor at New York Univer­sity, developed and introduced the Z-score formula in the late 1960s as a solution to the time-c­ons­uming and somewhat confusing process investors had to undergo to determine how close to bankruptcy a company was. In reality, the Z-score formula Altman developed ended up providing investors with an idea of the overall financial health of a company.

The Altman Z-Score Formula

The Altman Z-score is the output of a credit­-st­rength test that helps gauge the likelihood of bankruptcy for a publicly traded manufa­cturing company. The Z-score is based on five key financial ratios that can be found and calculated from a company's annual 10-K report. The calcul­ation used to determine the Altman Z-score is as follows:

Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

In this equation:
A = Working capita­l/total assets
B = Retained earnin­gs/­total assets
C = Earnings before interest and taxes (EBIT)­/total assets
D = Market value of equity­/book value of total liabil­ities
E = Sales/­total assets
Typically, a score below 1.8 indicates that a company is likely heading for or is under the weight of bankru­ptcy. Conver­sely, companies that score above 3 are less likely to experience bankru­ptcy.
 

Altman Z Score Diagram

Altman Z Score

Shortfalls of the Z-Score

The Z-score also isn't much use for new companies with little to no earnings. These companies, regardless of their financial health, will score low. Moreover, the Z-score doesn't address the issue of cash flows directly, only hinting at it through the use of the net working capita­l-t­o-asset ratio. After all, it takes cash to pay the bills.

Z-scores can swing from quarter to quarter when a company records one-time write-­offs. These can change the final score, suggesting that a company that's really not at risk is on the brink of bankru­ptcy.

Alas, the Z-score is not perfect and needs to be calculated and interp­reted with care. For starters, the Z-score is not immune to false accounting practices. As WorldCom demons­trates, companies in trouble may be tempted to misrep­resent financ­ials. The Z-score is only as accurate as the data that goes into it.

The Z-score also isn't much use for new companies with little or no earnings. These companies, regardless of their financial health, will score low. Moreover, the Z-score doesn't address the issue of cash flows directly, only hinting at it through the use of the net working capita­l-t­o-asset ratio. After all, it takes cash to pay the bills.

Finally, Z-scores can swing from quarter to quarter when a company records one-time write-­offs. These can change the final score, suggesting that a company that's really not at risk is on the brink of bankru­ptcy.

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