Altman Z-Score

The Altman Z-Score calculation integrates a few important financial ratios together in order to arrive at a probability of bankrupcy for a company.  The Z-Score model has been configured to assign different weighting to each of these ratios in proportion to their importance.  As with any formula, you cannot apply a broad stroke over the entire marketplace; therefore, Altman created different weighting for different sectors in this market such as Private Firms, manufacturers, & industrial companies.

Components of Z Score

Let's review the components, referenced as Z1 - Z5

Z1 = Working Capital / Total Assets
T1 is a liquidity measure that determines how liquid a companies assets are.  This ratio allows us to understand, in the event of a crisis, how quickly a company will be able to shore up cash.

Z2 = EBIT / Total Assets
Z2 measures overall profitability of the company

Z3 = Net Sales / Total Assets
Z3 measures how quickly the company is turning their assets over.  The higher this number, the better.

Z4 = Market Value of Equity / Total Liabilities
Z4 measures equity fluctuations which can potentially warn of trouble ahead.  Lehman Brothers, Freddie Mac, and Fannie Mae were all great examples of this during the Credit Meltdown of 2008.

Z5 = Retained Earnings / Total Assets
Z5 is a profitability measure assessing the companies earning potential.

Z - Score Weightings

Now, let's review the weights that are attached to each of these components.

Public Companies

ZScore = 1.2 * Z1 + 3.3 * Z2 + Z3 + .6 * Z4 + 1.4 * Z5

The net result of this formula has the following implications:

Z-Score > 3 - Implies that a company has solid financial footing
Z-Score Between 2.7 & 3 implies an area where investors should start to apply caution with this stocks
Z-Score Between 1.8 and 2.7 implies bankrupcy potential within the next 2 years
Z-Score below 1.8 implies strong probability of bankrupcy.

There is a great calculator of Z-Score at CreditGuru.