The Altman Z-Score Calculator is a powerful financial tool used to assess the likelihood of a company facing bankruptcy within the next two years. Developed by Edward I. Altman in the 1960s, this formula has become a standard metric for evaluating the financial health of manufacturing firms, although it can also be adapted for non-manufacturing and private companies.
Understanding the Altman Z-Score
The Altman Z-Score predicts business failure by examining the financial ratios from a company’s balance sheets and income statements. It combines five different financial ratios, each weighted differently, to produce a single number—the Z-Score—that indicates the company’s financial stability.
Formula and Inputs
The formula used in the Altman Z-Score Calculator is as follows:
Z=1.2X1+1.4X2+3.3X3+0.6X4+1.0X5Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5Z=1.2X1+1.4X2+3.3X3+0.6X4+1.0X5
Where:
- X1 = Working Capital / Total Assets
- X2 = Retained Earnings / Total Assets
- X3 = Earnings Before Interest and Taxes (EBIT) / Total Assets
- X4 = Market Value of Equity / Total Liabilities
- X5 = Sales / Total Assets
These ratios involve various components:
- Working Capital is Current Assets minus Current Liabilities.
- Retained Earnings include profits kept in the company after dividends are paid.
- EBIT represents operational profitability.
- Market Value of Equity is calculated from the company’s current stock price and shares outstanding.
- Sales refers to the total revenue.
Calculating the Z-Score
To calculate the Z-Score:
- Compute each of the five ratios using data from financial statements.
- Multiply each ratio by its respective weight in the formula.
- Add the results to get the Z-Score.
Interpreting the Z-Score
The outcome provides insight into the company’s financial health:
- Z > 2.99: Indicates a low likelihood of bankruptcy.
- 1.81 < Z < 2.99: Suggests some risk of financial distress.
- Z < 1.81: Signals a high risk of bankruptcy.
Step-by-Step Example
Let’s calculate the Z-Score for a hypothetical company:
- Working Capital: $200,000
- Total Assets: $1,000,000
- Retained Earnings: $150,000
- EBIT: $120,000
- Market Value of Equity: $500,000
- Total Liabilities: $400,000
- Sales: $950,000
- Calculate the ratios:
- X1 = $200,000 / $1,000,000 = 0.2
- X2 = $150,000 / $1,000,000 = 0.15
- X3 = $120,000 / $1,000,000 = 0.12
- X4 = $500,000 / $400,000 = 1.25
- X5 = $950,000 / $1,000,000 = 0.95
- Apply the formula:
- Z = (1.2 * 0.2) + (1.4 * 0.15) + (3.3 * 0.12) + (0.6 * 1.25) + (1.0 * 0.95)
- Z = 0.24 + 0.21 + 0.396 + 0.75 + 0.95
- Z = 2.546
The Z-Score of 2.546 places this company in a grey area, suggesting some risk of financial distress.
Table of Financial Ratios
| Ratio Description | Formula | Example Value |
|---|---|---|
| Working Capital / Total Assets | Working Capital / Total Assets | 0.2 |
| Retained Earnings / Total Assets | Retained Earnings / Total Assets | 0.15 |
| EBIT / Total Assets | EBIT / Total Assets | 0.12 |
| Market Value of Equity / Liabilities | Market Value of Equity / Liabilities | 1.25 |
| Sales / Total Assets | Sales / Total Assets | 0.95 |
Conclusion
The Altman Z-Score Calculator offers invaluable insight into a company’s financial robustness, helping stakeholders make informed decisions regarding financial risks. It is particularly useful for investors, creditors, and company management to assess and act on potential financial challenges ahead. By understanding and utilizing this tool, businesses can strategically steer clear of financial pitfalls, ensuring a more secure economic future.