Friday, 24 July 2020

What is Altman’s Z-Score Model?



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.


 Altman’s Z-score Model Explained

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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