The Corporate Finance Institute
published an article on the above. We have largely followed their views and
reproduce substantially the article.
Altman’s Z-Score model is a numerical measurement that is used
to predict the chances of a business going bankrupt in the next two years. The
model was developed by American finance professor Edward Altman in 1968 as a
measure of the financial stability of companies.
The
Z-score model was introduced as a way of predicting the probability that a
company would 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.
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.
Later in 1983, Altman developed two other models
for use with smaller private manufacturing companies. Model A Z-score was
developed specifically for private manufacturing companies, while Model B was
created for non-publicly traded companies. The 1983 Z-score models comprised
varied weighting, predictability scoring systems, and variables.
Altman’s Z-score Model Formula
The Z-score model is based on five key financial
ratios. The Altman’s Z-score formula is written as follows:
ζ = 1.2A + 1.4B +
3.3C + 0.6D + 1.0E
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
What Z-Scores Mean
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.
Investors use the Altman’s Z-score to make a
decision on whether to buy or sell a company’s stock, depending on the assessed
financial strength. If a company shows a Z-score closer to 3, investors may
consider purchasing the company’s stock since there is minimal risk of the
business going bankrupt in the next two years.
However, if a company shows a Z-score closer to
1.8, the investors may consider selling the company’s stock to avoid losing
their investments since the score implies a high probability of going bankrupt.
As an example, low
Altman Z-Scores were recorded for the following five companies (by Andy
Snyder):
·
Eastman Kodak Company (NYSE: KODK)
Altman Z-Score: .99
Kodak is having some problems. Even before
this coronavirus mess, the company was having trouble keeping up in the digital
age.
·
Uber Technologies Inc (NYSE: UBER)
Altman Z-Score: .97
You might not be surprised to hear that
Uber has a score of .97. That’s because it has $17 billion in debt and $4.7
billion in negative free cash flow each year. That’s a problem. A lot of debt
and cash going out the door. So it’s in need of financing and the coronavirus
has only made it worse.
·
3D Systems Corporation (NYSE: DDD)
Altman Z-Score: .97
3D Systems’ numbers are a little bit
better. It has $24 million in positive cash flow, but it does have about $300
million in debt. So it has some issues.
·
YRC Worldwide Inc (NASDAQ: YRCW)
Altman
Z-Score: .92
YRC Worldwide is a big trucking company. After 2008 it had some issues. Its score is
.92 and it has $120 million in negative cash flow.
·
Timkensteel Corp (NYSE: TMST)
Altman
Z-Score: .74
Timkensteel had some problems going into
the Covid-19 pandemic. If we start to see stimulus spending and greater
infrastructure spending, steel could be really big.
Remember, with all five of these companies,
just because they’re on the bankruptcy watch list does not mean they are going
bankrupt. But any company with an Altman Z-Score above 3 may offer investors a
good opportunity.
Disclaimer
We
are not recommending any particular counter nor accept any liability or loss
for the stocks mentioned above.
References:
1. What
is Altman’s Z-Score Model? Corporate Finance Institute (https://corporatefinanceinstitute.com)
2. Altman
Z-Score – 5 Companies at Risk for Bankruptcy, Andy Snyder, June 3, 2020
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