The Altman Z-score is a combination of five weighted business ratios that is used to estimate the likelihood of financial distress. If the credit crunch itself wasn’t lesson enough, respected fund manager Anthony Bolton has emphasised the importance of understanding credit risk when investing in equities: “When I analysed the stocks that have lost me the most money, about two-thirds of the time it was due to weak balance sheets. You have to have your eyes open to the fact that if you are buying a company with a weak balance sheet and something changes, then that’s when you are going to be most exposed as a shareholder.”
Background to the Z-Score
The Z-Score was developed in 1968 by Edward I. Altman, an Assistant Professor of Finance at New York University, as a quantitative balance-sheet method of determining a company’s financial health. A Z-score can be calculated for all non-financial companies and the lower the score, the greater the risk of the company falling into financial distress.
The original research was based on data from publicly held manufacturers (66 firms, half of which had filed for bankruptcy). Altman calculated 22 common financial ratios for all of them and then used multiple discriminant analysis to choose a small number of those ratios that could best distinguish between a bankrupt firm and a healthy one. To test the model, Altman then calculated the Z Scores for new groups of bankrupt and nonbankrupt but sick firms (i.e. with reported deficits) in order to discover how well the Z Score model could distinguish between sick firms and the terminally ill.
The results indicated that, if the Altman Z-Score is close to or below 3, it is wise to do some serious due diligence before considering investing. The Z-score results usually have the following "Zones" of interpretation:
- Z Score above 2.99 -“Safe” Zones. The company is considered ‘Safe’ based on the financial figures only.
- 1.8 < Z < 2.99 -“Grey” Zones. There is a good chance of the company going bankrupt within the next 2 years of operations.
- Z below 1.80 -“Distress” Zones. The score indicates a high probability of distress within this time period.
The Z-score has subsequently been re-estimated based on other datasets for private manufacturing companies, as well as non-manufacturing / service companies.
Does the Altman Z-Score Work?
In its initial test, the…