Altman Z Score as Bankruptcy and Quality Check
What You Will Learn
- An explanation of each component of the Altman Z score
- When and how to use it
- Why it is still relevant
- Free Altman Z spreadsheet download
What is the Altman Z Score?
The Altman Z-Score formula was originally dveloped by Edward Altman, an assistant professor at NYU (at the time). It was designed to predict the probability that a company would go bankrupt within two years using financial metrics that assess solvency, profitability, leverage, liquidity, and turnover.
The focus of this model is to protect your downside. A high Altman Z Score does not represent a good buy; however, a low failing score raises red flags that you should dig into.
The main problem with the Altman Z formula is that the formula is not suited for many industries. Industries that operate with high leverage, such as radio, airlines and utilities will show a higher risk of bankruptcy.
Industries with negative working capital, such as many retail and restaurant companies will also exhibit the same high level of bankruptcy.
It’s also been shown to be less predictive than it used to be.
So, Is the Altman Z Score Dead?
The Altman Z score is useless.
It no longer works.
That’s what these reports argue. They say that the Altman Z Score is dead and here is an honest limitation of the model.
And another really good pdf report on why the Altman Z model does not work for turnaround companies.
The Altman Z Score Formua
The basic formula may look complicated, but we’ll break it down for you.
Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 +1 X5
- X1 = Working Capital / Total Assets
- X2 = Retained Earnings / Total Assets
- X3 = EBITDA / Total Assets
- X4 = Market Value of Equity / Total Liabilities
- X5 = Net Sales / Total Assets
I’ll get to what each one means, but first, Here are the rules for interpreting the Altman Z score.
- When Z is >= 3.0, the firm is most likely safe based on the financial data.
- When Z is 2.7 to 3.0, the company is probably safe from bankruptcy, but this is in the grey area and caution should be taken.
- When Z is 1.8 to 2.7, the company is likely to be bankrupt within 2 years.
- When Z is <= 1.8, the company is highly likely to be bankrupt.
Does That Mean the Altman Z Score is Useless?
Regardless of what reports say, I still continue use it.
In fact, I’ve created pretty charts to quickly look up Altman Z scores within the Old School Value Stock Analyzer.
Here’s a zoomed out view of the information I verify when looking at the quality checks.
The reports above dive into the Altman Z score and concludes that the variables that make up the Altman Z score are no longer predictive of bankruptcy.
But that’s not why I use it.
Why I Use the Altman Z Score to Assess Quality
It may be true the predictive effectiveness has dropped of when it comes to determining bankruptcy, but for most investments, it’s the quality that matters.
Not whether a company is going go to bankrupt.
For companies teetering on the edge of bankruptcy, it’s an easy tell.
- Overloaded debt
- Underfunded pension funds with unrealistic high returns expected
- Short term debt > long term debt
- Cash from financing > cash from operations
- and so on
A quick look at the financial statements is all that is needed to stay away from companies like this.
But here’s how to use the Altman Z score to its full potential.
Break up the formula and use it as individual ratios.
Instead of focusing on calculating Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 +1 X5, zero in on each component.
The components of the Z score aren’t rocket science.
Just simple, well thought out ratios covering all your main bases:
Let’s take a look at each of the variables and see what it can indicate in a company.
But first, before we dive in, if you haven’t done so, click this image and enter your email. You’ll get a link to download an Altman Z score spreadsheet which will help you understand this topic better.
Altman X1 = Working Capital / Total Assets
Working Capital/Total Assets = (Current Assets – Current Liabilities)/Total Assets
This is a simple ratio to understand.
This ratio provides information about the short term financial position of the business based on the balance sheet.
The more working capital there is compared to the total assets, the better the liquidity situation.
With working capital you still have to remember two points.
Point #1: Negative working capital isn’t always bad
Companies with high inventory turnover can have negative working capital. If you take a look at Wal-Mart (WMT), it has leverage over their suppliers with favorable payment terms so their current liabilities can outweigh their current assets.
Other examples include telecom companies such as Verizon (VZ) and airlines like Southwest (LUV) and Allegiant (ALGT).
Point #2: High positive working capital isn’t always good
Just because working capital is high, it doesn’t automatically mean that it is good.
It can indicate the company has too much inventory or they are not investing their excess cash.
Altman X2 = Retained Earnings / Total Assets
Retained earnings is the percentage of net earnings that isn’t paid out as dividends – hence the word “retained”.
The company will use it to operate the business. It can be reinvested or used to pay off debt. Up to management.
But when you combine it total assets, the purpose of the ratio is now to measure how much the company relies on debt.
If a company has little to no retained earnings, then it has to get money from somewhere to continue with operations. Where does that money come from? Debt or dilution.
The lower the ratio, the company is funding assets by borrowing instead of through retained earnings.
This ratio is also a cousin to the equity multiplier used in the DuPont Analysis where Equity Multiplier = Total Assets/Shareholders Equity
Altman X3 = EBIT / Total Assets
If you squint hard enough at EBIT/Total Assets, it will look familiar.
It’s a variation of a common ratio that you see everywhere.
Don’t see it? Neither did I.
EBIT/Total Assets is a variation of ROA.
Instead of net income, EBIT is used in the numerator.
ROA = Net Income/Total Assets
The definition is the same though.
This ratio looks at the company’s ability to generate profits from its assets before deducting interest and taxes.
Altman X4 = Market Value of Equity / Total Liabilities
Out of the 5 components, this is the most controversial.
This ratio is supposed to show you how much of the company’s market value could decline before liabilities exceed assets.
The weakness is the market value of equity, aka market cap or stock price x shares outstanding.
The problem is that if the stock price is high, then this ratio goes up.
Here are two examples
- Market Cap: 51.18B
- Total liabilities: 17.54B
- Market Value of Equity / Total Liabilities = 51.18/17.54 = 2.9
- Market Cap: 3.69B
- Total liabilities: 217.15M
- Market Value of Equity / Total Liabilities = 3.69/0.217 = 17
Both companies have negative PE’s, but because of Wix.com’s stock price compared to Tesla, it has a higher ratio.
Of the 5 Altman Z score components, #4 is the least important and the one I use the least.
Altman X5 = Net Sales / Total Assets
This ratio is just asset turnover.
I use it all the time outside of the Altman Z score as well as it is a great indicator of efficiency and business quality when comparing against previous years.
Quite simply, it is looking at the dollar of sales generated by the company for every dollar of assets.
The more money you can generate from assets, the better.
If two people start with $1,000 in total assets, but person A generates $1,000 while person B generates $2,000, the winner is a no-brainer.
Screen for Stocks using the Altman Z Score and Components
One of the things we do at old school value is to provide off-the-wall type value metrics. Instead of sticking with the same ratios and numbers every other screener has, we include Altman Z scores as well as each component.
Go to OSV Online, click on screener and then type in “Altman” or click the Altman category to expand the possible data selections.
Even if you don’t have access, you can play with it in the live preview mode. Click to view, then go to screener.
Free Altman Z Screener
To get a list of stock ideas where the Altman Z Score is higher than 3, you can use the free Altman Z Screener.
The free screens are updated weekly with fresh stock ideas.
Free Altman Z Spreadsheet
As the last cherry on top, download the free Altman Z spreadsheet I have prepared for you.
Put it into practice with the free Altman Z score spreadsheet. Click on the image and get it via email.
Keep in mind that the actual Altman Z score is not a clear bankruptcy indicator.
In fact, there is no such thing. There are other models to try and predict bankruptcy, but nothing is accurate.
It all comes down to how you put it into context and make use of it.