What is Altman Z-Score?

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The Altman Z-score is the output of a credit-strength test that gauges a publicly traded manufacturing company's likelihood of bankruptcy.

Definition

The Altman Z-Score is a credit strength test that measures the likelihood of bankruptcy for publicly traded manufacturing companies. It analyzes a company's financial statements to calculate a score that predicts the probability of bankruptcy within the next two years. This score is derived from a weighted combination of five financial ratios, designed to help investors and analysts identify early signs of financial distress.

Origin

The Altman Z-Score was first introduced by Professor Edward Altman of New York University in 1968. Altman developed this model by studying the financial data of 66 manufacturing companies to better predict the risk of bankruptcy. Since then, the Z-Score has been widely used in financial analysis and risk management.

Categories and Features

The Altman Z-Score is primarily applicable to manufacturing companies, especially those that are publicly traded. Its calculation formula includes five key financial ratios: working capital/total assets, retained earnings/total assets, earnings before interest and taxes/total assets, market value of equity/book value of total liabilities, and sales/total assets. Each ratio has a specific weight in the formula, resulting in a composite score. Generally, a Z-Score above 2.99 indicates financial health, between 1.81 and 2.99 suggests financial instability, and below 1.81 indicates a high risk of bankruptcy.

Case Studies

A typical case is the financial situation of Enron before its bankruptcy in 2001. Although Enron's financial statements appeared healthy before bankruptcy, its Altman Z-Score was below 1.81, indicating potential financial crisis. Another example is the 2008 bankruptcy of Lehman Brothers. Although Lehman Brothers was a financial company, the Altman Z-Score could still be adapted for analysis, showing early signs of financial distress.

Common Issues

Common issues investors face when using the Altman Z-Score include its limited applicability to non-manufacturing companies and its reliance on the accuracy of financial statement data. Additionally, the Z-Score should not be used as the sole basis for investment decisions but should be combined with other financial analysis tools and market information for a comprehensive evaluation.

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